S&P 500 needs Fed cut, earnings boost to avoid looking frothy

by Alexandra Semenova

Few times in history has the US market grappled with as many headwinds as it’s faced in 2025: a new president rejiggering the global order, sweeping tariffs and a bout of uncertainty stemming from conflict in the Middle East. Stocks have still prevailed against all odds and sit just a whisker away from all-time highs.

But the higher the S&P 500 Index goes, the louder the concern that its multiples are starting to look frothy. The index is trading at 22 times expected profits in the next 12 months, 35% above its long-term average, data compiled by Bloomberg show. Of the 20 such valuation metrics tracked by Bank of America Corp. strategists, the S&P 500 is screening expensive on each one.

While valuations are unlikely market-timing tools, with stock prices revving louder than the corporate engines of the S&P 500 firms, one back-of-the-envelope measure shows just how extreme the disconnect on the valuation charts has become. That’s at a time when investors are about to confront some crucial risks. US President Donald Trump’s self-imposed July 9 deadline to reach deals with the country’s major trading partners is fast approaching, and the next earnings cycle starts soon after.

A Bloomberg Intelligence model, which factors in inputs like Treasury yields, per-share earnings and equity risk premium, shows that the S&P 500’s fair price-to-earnings multiple should hover near 17.7 on a trailing basis, compared with 23.7 where it’s trading now. For the p/e ratio to return to its fair-value level, the gauge’s earnings would need to rise 30% over the next year, assuming prices remain the same.

“Current levels for the market are sustainable, but it’s the ‘from here’ where we can’t have high conviction,” said Kevin Gordon, senior investment strategist at Charles Schwab & Co. “There is likely too much earnings optimism baked in for the back half of the year, and when you combine that with the fact that multiples are right near cycle highs, it puts even more pressure on earnings to exceed expectations. It’s not an impossible task, but it’s a high bar.”

Apart from earnings growth, dramatic interest-rate cuts from the Federal Reserve would be another way for the S&P 500 to narrow the gap between fundamentals and market prices, according to Bloomberg Intelligence strategists Gina Martin Adams and Michael Casper. They didn’t quantify how much easing from the central bank would suffice for this to happen.

On Tuesday, Fed Chair Jerome Powell reiterated his view that policymakers need not rush to adjust policy, but that lower inflation and weaker labor hiring could mean an earlier rate cut this year.

So far, even fundamentals being at odds with rising stock prices hasn’t stopped Wall Street strategists from suggesting that investors should use any potential pullbacks as buying opportunities — particularly to invest in technology and growth stocks. 

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