For the past five years, U.S. equities have seemingly defied gravity, consistently commanding premium valuations. Investors, buoyed by unprecedented pandemic-era stimulus and the transformative potential of artificial intelligence, pushed the S&P 500 to remarkable heights, enjoying a surge of over 140% from the COVID-19 lows. 

During this period, a Price-to-Earnings (P/E) ratio of 20x often acted as a floor for the index, with the average valuation settling closer to 26x, and even reaching dizzying peaks above 40x.

However, influential voices are now signaling a potential sea change. The analysis suggests that the factors underpinning these elevated valuations are beginning to wane, and markets could be poised for a return to more historically grounded levels.

Looking back, the post-2020 valuation environment stands out as an anomaly. The long-term average P/E ratio for the S&P 500 throughout the 20th century was closer to 14x. Even considering just the 21st century prior to the pandemic boom, the average was around 20x. This historical perspective underscores just how stretched valuations became.

Hartnett’s projections indicate that 2025 might represent the peak of this extraordinary valuation cycle. The strategist anticipates that the 20x P/E level, which recently served as a support level, could soon become a ceiling. 

This shift is predicated on several developing macroeconomic trends: accelerating de-globalization, potentially eroding central bank independence, diminishing fiscal and monetary support, inflation settling into a higher range (perhaps 3-4% outside of recessions), and an anticipated rise in the U.S. savings rate. In essence, the ubiquitous American exceptionalism, here fueled by massive spending and the absurd AI frenzy, may be losing steam.

Even today, metrics designed to smooth out short-term fluctuations, like the Shiller cyclically-adjusted P/E ratio, suggest U.S. stocks remain among the most expensive they’ve been in the last 100 years. Historically, such periods of high valuation often precede periods of lower forward returns for equity investors.

For valuations to revert to historical norms, one of two things generally needs to happen: stock prices must decline, or corporate earnings need to grow significantly faster than currently anticipated. Given prevailing risks, like the ongoing international trade tensions under Donald Trump and the persistent threat of inflation potentially dampening consumer spending (a key economic engine), strategists are leaning toward expecting downward pressure on stock prices rather than an unexpected earnings boom.

Consequently, the suggested investment posture shifts towards a more defensive stance, at least for the near term. This involves reducing exposure to potentially overvalued U.S. stocks and the U.S. dollar, while increasing allocations to assets perceived as offering better relative value or safety, such as bonds, gold, and international equities. For investors looking to implement such a strategy, broad-based ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG), the Vanguard Total International Stock ETF (VXUS), and SPDR® Gold Shares (GLD) are some accessible options.

Of course, uncertainty remains. Political figures might moderate policies, and economic data releases, particularly concerning employment and inflation, will be crucial in shaping market sentiment. However, the overarching message is becoming clearer: the unique tailwinds that propelled U.S. equity valuations to historic highs appear to be fading. Investors and advisors may need to adjust expectations for future stock market returns and re-emphasize the importance of diversification across different asset classes as we navigate this evolving financial landscape. The era of easy gains may be giving way to a more normalized — if potentially more challenging — market environment.