Post from First Trust Economics Blog

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

March 10th, 2025

It is true that tariffs are a tax. It is also true that tariff

policies have been volatile…on and off again…different carve

outs…different countries…phone calls that change things. All

of this clearly has an impact on the market. So, we are not

surprised to see stock market volatility.

However, it isn’t all about tariffs. Many major models of

overall stock market valuation show that the market is expensive.

The so-called Buffett Indicator, which measures the market cap

of the S&P 500 as a percent of GDP, says the market is

overvalued. The Shiller CAPE PE Ratio, which measures stock

prices compared to trailing 10-year inflation-adjusted earnings,

shows the market is overvalued. In other words, compared to

history, stock prices are on the high side.

Some argue that it’s different this time. That AI, and

technology in general are moving so fast, and so powerfully, that

historical measures don’t work. One way to deal with this is to

compare stock values and earnings to a discount rate…in other

words compare the stock market to the bond market.

The Fed Model, which compares the earnings yield of the

S&P 500 (the inverse of the PE ratio) to the 10-year Treasury

yield or to a corporate bond yield, shows that stock returns

relative to bond returns are the lowest since 2000 – the dot-com

bubble.

 

Our Capitalized Profits Model, which discounts current

profits by the 10-year Treasury yield, shows the same thing. We

are overvalued relative to past relationships of earnings and

interest rates. (To view all these charts, see our latest Three on

Thursday by following this link.)

However, as the saying goes, it is a market of stocks and

not a stock market. Just because these models say the market as

a whole is over-valued does not mean all stocks are over-valued.

But because the S&P 500 is so top heavy, with just 10 stocks

making up over 1/3rd of its total capitalization, it is hard for the

other 490 stocks to offset declines in these very large cap

companies.

Back on January 6th, we published our forecast for 2025.

Our expectation was for the S&P 500 to finish this year around

5,200. We have not changed our forecast. For the record, unless

earnings grow much faster than the consensus expects (around

10% this year), or the 10-year Treasury falls to 3% or below,

even at 5,200 the market would remain over-valued.

We think the policy changes that are underway will be

positive for long-term growth. Keeping tax rates low, cutting

regulations, and reducing the size of the government bureaucracy

will boost the underlying growth rate of the economy in the

future.

Unfortunately, the US economy has been artificially

boosted in recent years by massive deficits and a very loose

monetary policy. Reducing that artificial stimulus is like having

morphine wear off. We expect the economy to grow more slowly

this year, which means corporate profits are unlikely to grow

faster than the consensus expects.

In other words, what is good for the long-term makes the

short-term look worse. This is much like what happened with

Ronald Reagan in the early 1980s. Even though his policies led

to a boom in the economy, the fix (especially for inflation) was

a painful process.

So we are not surprised to see the stock market reaction of

the past few weeks. Investors have been so used to “buying the

dip” because the stock market has been a one-way trade, that

seeing it fall toward or into correction territory feels worse than

it really is. This compounds negative feelings and people start

looking for scapegoats.

We get it. But tariffs are just the catalyst, not the full

explanation. Don’t forget, when Reagan moved into the White

House, the PE ratio of the S&P 500 was about 8. When Donald

Trump moved back into the White House it was 28.

This doesn’t mean investors should abandon stocks

altogether. The valuation models we mentioned are not meant

for trading. They are indications of value. And when valuations

are high, there are still opportunities. To find them, we suggest

reading Dave McGarel’s Market Minute. As we said a few

weeks ago, “the era of easy everything is over.” And as McGarel

says in his Market Minute, “when you break stride it’s hard to

win the race.” Clearly the market has “broken stride,” which

shouldn’t be a surprise to anyone looking at heady valuations.