The Stock Market’s Biggest Challenge in 2025: A Historical Perspective
As we close the book on 2024, it’s clear that the stock market had a remarkable year, with the S&P 500 advancing by about 25%. However, this success has set the stage for what could be the biggest challenge facing the stock market in 2025 – its rich valuation. According to historical data, the S&P 500 is currently sporting a price-to-sales (P/S) ratio of 2.84x, which is the highest reading since 2021 and one of the highest readings on record.
The High Cost of Stocks: A Historical Context
To put this in perspective, let’s examine the S&P 500’s P/S ratio over time. Going back to 2005, the average P/S ratio for the S&P 500 is around 1.79x. This means that the current ratio is roughly 59% higher than the average. What’s more, valuations seem astronomical when compared to the S&P 500’s average P/S ratio in the 20th century. For example, the S&P’s P/S ratio remained below 1.0x for over 25 years between 1969 and 1995, with an average of about 0.66x and a low of 0.35x in 1982.
Granted, there are some structural reasons why investors are willing to pay more for stocks now than 40 years ago, such as the rise of individual retirement accounts at the expense of traditional pension plans. Nevertheless, given how high the stock market’s valuation is today, some reversion toward the historical mean seems inevitable. So, what does history have to say about how that will happen?
How (and When) Valuations Fall
Since the P/S ratio is a ratio, there are two ways it can contract: The numerator (stock prices) can fall, or the divisor (revenue) can rise. While both of these methods would result in a lower ratio, in practice, only the numerator tends to bring down the ratio. That’s because rising revenue tends to result in increased optimism in the stock market. After all, investors are more likely to pour money into the stock market if companies are reporting better-than-expected sales.
On the other hand, pessimism brings stock prices down, even if revenue is holding steady or even increasing. This is easy to see during recessions. Take 2007 through 2009, for example. During this period, stock prices fell by more than 50%, leading to the S&P 500’s P/S ratio dropping from a high of 1.52x in 2007 to a low of 0.80x in 2009.
Economic Concerns: A Potential Catalyst for Correction
As 2025 gets started, there are economic concerns that could potentially bring down stock prices and the S&P 500’s P/S ratio. For example, the incoming Trump administration plans to increase tariffs – a measure that could stifle economic growth and cut into corporate earnings. In addition, inflation remains slightly above the Federal Reserve’s long-term goal of 2%. If inflation were to remain at that level or, even worse, climb, the Fed may need to shift gears and either halt its interest rate cuts or reverse them altogether and raise rates.
A Correction Awaits: Staying Invested Through a Diversified Portfolio
The takeaway for investors is to focus on their long-term investment goals, which are best served by staying invested in the market through a diversified portfolio. With the stock market’s high valuation, a correction shouldn’t come as a surprise. Investors should be prepared for this eventuality and avoid getting caught off guard.
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Conclusion
In conclusion, the stock market’s high valuation is a challenge that it will need to overcome in 2025. While history suggests that valuations tend to fall when they are too high, the exact timing and manner of this correction cannot be predicted with certainty. Nevertheless, investors can take steps to prepare for this eventuality by staying invested through a diversified portfolio and focusing on their long-term investment goals.
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