The S&P 500 surpassed the 7,600 level for the first time this week, renewing debate over whether the index’s impressive run since the end of 2022 reflects underlying profit growth or an expansion in how much investors are willing to pay for those profits.
Capital Economics examined the rally and concluded that the answer depends on the valuation metric employed. Chief Economic Adviser John Higgins told investors that the two commonly used frameworks - a forward earnings lens and a cyclically adjusted, inflation-adjusted measure - point to sharply different interpretations.
Forward earnings view
When the rally is evaluated using forward twelve-month earnings per share (EPS), the movement looks largely fundamental. Under this approach, growth in expected EPS accounts for a substantially greater share of the S&P 500’s appreciation since end-2022 than expansion in the forward price-to-earnings multiple. That pattern suggests the advance has been driven by improving corporate profitability rather than by investors paying higher multiples alone.
Cyclically adjusted view
Applying a cyclically adjusted methodology - the Shiller CAPE ratio that uses real, inflation-adjusted trailing earnings - yields the opposite conclusion. Breaking the real increase in the index down into components using the CAPE, Capital Economics found that an increase in valuation multiples consistent with speculative behavior accounts for the bulk of gains. "Gains in the S&P 500 since the end of 2022 have been fuelled far more by 'speculation,'" Higgins wrote.
Higgins highlighted that the divergence between the two perspectives stems from the way earnings are measured. Forward EPS have climbed sharply in recent years, which has held down the level of the price-to-forward-earnings ratio. By contrast, real trailing earnings have expanded more slowly. The CAPE has risen by nearly 13 points since the end of 2022, while the forward multiple has increased by roughly 4 points over the same period, leaving the Shiller-based metric at relatively elevated levels.
Summing up the firm’s analysis, Higgins observed that whether the S&P 500’s surge is judged to be fundamentally based or speculative in nature depends on which valuation framework one adopts.