The Valuation Problem

This is an excerpt from Yardeni Research Morning Briefing dated Monday, March 17, 2025.

Last Thursday, I visited with some of our accounts in Connecticut. They seemed remarkably relaxed that day as the S&P 500 fell into correction territory. Many of them are seasoned institutional investors and have been through lots of corrections and bear markets. Everyone attributed the selloff to Trump Tariff Turmoil 2.0.

The bulls still believe (hope) that President Donald Trump is using tariffs as a bargaining tool to negotiate lower tariffs with America’s major trading partners. Some of them predict that if that’s not the case, then Trump will back off in response to political pressure to do so from lots of constituencies that stand to be harmed by a trade war. He might also back off if the stock market continues to tank. The bears warn that by the time Trump ever would relent, the economy would be in a consumer-led recession and the stock market surely would be in a bear market.

We remain bullish, but less so. On Wednesday, March 5, Eric, Debbie, and I raised the odds of a bearish scenario from 20% to 35%. That might entail an outright recession or a period of stagflation. On March 9, we wrote: We can’t rule out the possibility that a bear market started on February 20, the day after the S&P 500 rose to a record high. On March 13, we lowered our year-end 2025 S&P 500 target from 7000 to 6400.

We continue to bet on the resilience of the consumer, the economy, and corporate earnings, but we reckon that heightened recession fears will weigh on valuation multiples. We acknowledge that the risks of a recession and a bear market might continue to increase. It all depends on the often-unpredictable President, who frequently—and proudly—has referred to himself as “Tariff Man,” reflecting his strong support for protectionist trade policies.

We all know that the S&P 500 forward P/E and P/S are stretched by historical standards (Fig. 1). The latter, which is simply a weekly version of the Buffett Ratio, rose to a record high of 3.04 on December 4 (Fig. 2). It was back down to 2.75 last week, which is still very high. The forward P/E ratio remained below its previous two cyclical highs because the rising forward profit margin boosted earnings relative to revenues (Fig. 3). Nevertheless, the forward P/E was high at 20.2 last week, though down from a recent peak of 22.3 during the December 6 week.

We’ve argued that high valuation multiples might be sustainable if there is no recession in sight. Since the S&P 500 peaked at a record high on February 19, concerns about a recession caused by Trumps tariffs have been mounting, as we acknowledged by raising our subjective odds of a recession. Nevertheless, we didn’t change our optimistic outlook for forward earnings (Fig. 4). But we did lower our range for the forward P/E from 18-22 to 18-20 (Fig. 5).

The Nasdaq, which peaked at a record high on December 16, fell into correction territory (down 10%-20%) on March 6 (Fig. 6). It is down 12.0% through Friday. The S&P 500 fell into correction territory last Thursday and was down 8.2% from its record peak on Friday (Fig. 7).

Corrections occur when the stock market starts to discount a recession that doesn’t occur. It is almost always attributable to a drop in the forward P/E, while forward earnings continue to rise (or at least don’t fall). A bear market (down 20% or more) typically occurs when a recession happens, sending both the valuation multiple and earnings expectations tumbling. Only a few bear markets have occurred when no recession unfolded (i.e., in 1962, 1987, and 2022).

Now let’s turn to the case for a bear market followed by the case for a resumption of the bull market following the latest corrections in the Nasdaq and the S&P 500.

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