“Is the S&P 500 Riding a Bubble? Understanding Its Overvaluation”

Welcome back! Each development from the White House triggers different reactions in the S&P 500, with rallies or sell-offs. But is the market overlooking the broader issues?

Even with indications of a slowing US economy, Donald Trump’s tariff strategies, and pervasive uncertainty, Wall Street analysts predict the main US stock index will finish 2025 at around 6,000 on average. This implies an increase of at least 5 percent for the S&P 500 by the end of the year.

This week, I’ll present the argument for why I think the market is mistaken, and that the S&P 500 is likely to wrap up this year significantly lower than its current value of 5,525.

End-of-year stock market predictions ultimately hinge on investors’ annual economic perspectives and their views on structural influences, like artificial intelligence and US exceptionalism.

For 2025, analysts essentially anticipate the S&P 500 to remain nearly stable compared to last year. This marks a significant drop from the past two years where we saw annual growth exceeding 20 percent. But could it still be overly optimistic?

Let’s start with the economic fundamentals. Last month, I contended that the US was on the cusp of a recession. This assertion stemmed from economic challenges as Trump began his second term, uncertainties surrounding his policies, and potential import tariffs. I recognize this perspective isn’t the consensus on Wall Street, at least not yet.

Analysts are more focused on specific tariff announcements. In fact, since “liberation day,” overall growth forecasts for 2025 have declined, and the likelihood of a recession in the next 12 months has increased to 45 percent. Most anticipate the US effective tariff rate (excluding substitution effects) to settle between 10 and 20 percent this year, down from an estimated 28 percent, which started 2025 near 2.5 percent.

These projections seem plausible, representing notably heightened tariffs compared to last year and slower growth, even in the absence of a recession. Nevertheless, the market seems to be pricing in a more optimistic future.

“The signals from risk assets indicate that markets don’t expect a mild slowdown to occur this year,” remarked Daniel Von Ahlen, a senior macro strategist at TS Lombard, using a straightforward regression model to gauge US growth predictions from asset prices.

Current expectations for corporate earnings this year seem overly optimistic. It is simpler for Wall Street to base their buy and sell decisions on perceived risk events. Assessing how these events affect company profits often takes longer.

“Normally, earnings estimates decline even during mild recessions,” stated Peter Berezin, chief global strategist at BCA Research. “However, the market currently anticipates around 10 percent earnings growth over the next year, which is off last year’s peak profit margins.”

Analysts may be overly hopeful about the ability of businesses to transfer any tariff expenses onto consumers. The sectors most affected—industrials, materials, and consumer discretionary—have limited pricing power, according to BCA Research’s US equity strategy team.

If companies find it challenging to considerably raise prices, tariffs imposed by Trump could lower S&P 500 net income margins by 2.2 percentage points. Under these assumptions (based on a 10 percent tariff rate across the board, returning Chinese import duties to their pre-retaliation rate of 54 percent, and specific levies on steel, aluminum, and cars at 25 percent), this would lead to a 19.2 percent fall in S&P 500 earnings per share.

For context, Goldman Sachs estimates that every 5 percentage point increase in the US tariff rate results in a decline of around 1 to 2 percent in S&P 500 EPS.

Regardless of one’s views on tariffs, the consensus forecasts for earnings per share (EPS) growth in 2025 seem mismatched to the current economic landscape: significant uncertainty, lackluster consumer and investor confidence, and elevated import tariffs. (In two weeks, the number of scheduled vessels heading to the Port of Los Angeles is expected to drop significantly year-on-year.)

Quick changes in earnings projections are occurring now. The quantity of earnings downgrades by analysts for 2025 is surprisingly at levels typically associated with recessions, although the actual extent of these downgrades remains relatively mild. As earnings expectations decrease, stock prices are likely to follow, in line with analysts adjusting their valuations.

For context, the forward price-to-earnings ratio (how much investors are willing to pay for each dollar of projected earnings) is currently around 19, compared to nearly 17 in the five years before the pandemic, and averaging around 10 during any recession since 1980.

Using Goldman Sachs’ sensitivity matrix for the S&P 500, a moderately conservative estimate for EPS growth of 3 percent this year, coupled with a return of forward P/E ratios to just above their pre-pandemic averages, could place the index closer to 4,550.

Of course, the S&P 500 could potentially avoid such a steep drop if structural changes stimulate buying.

However, the AI narrative is facing challenges. The launch of DeepSeek’s low-cost model in China has drawn attention to the vast sums US tech firms are committing to AI development. Trump’s trade announcements—including proposed tariffs on Asian tech manufacturing hubs and restrictions on chip exports—have further complicated matters.

“We are still waiting for a groundbreaking application that justifies the substantial capital investments being made. The low barriers for creating large language models also raise further doubts about the revenue that the Magnificent Seven can generate,” explained Hugh Grieves, a fund manager at Premier Miton Investors. “[They] are also slowly coming to terms with how tariffs affect their profits.”

Stock prices of the Magnificent Seven tech firms have significantly declined since Trump took office. However, analysts remain uncertain about what these valuations reflect. These companies represent one-third of the S&P 500’s market capitalization and significantly influence overall net profit margin estimates. Therefore, offloading these shares is an easy way to mitigate risk exposure amid fluctuating news.

Despite this, their forward P/E multiples are still elevated compared to pre-pandemic times (both individually and collectively). Prices may continue to decrease as their profitability takes a hit, factoring in both tariffs and the AI hype.

Next, let’s consider US exceptionalism. For many years, the US has drawn

Capital has a solid foundation due to its strong liquidity, stability, and the safe-haven nature of its assets, which has allowed the S&P 500 to surpass its economic fundamentals.

However, this trend is starting to weaken. In March, participants in Bank of America’s Fund Manager survey reported the largest drop in their US equity holdings ever recorded. Tariffs disproportionately affect America, with its companies benefiting the most from the “Made in Asia” model, as noted by Matt King, founder of Satori Insights. (Retaliatory tariffs could also harm US businesses.)

Frequent policy changes, increasing uncertainty, rising risks to financial stability, and assaults on independent economic institutions—like the US Federal Reserve—make the US a less appealing destination for capital.

“The US has shifted from being the ‘cleanest dirty shirt’ to one of the least attractive yet still priciest garments in the investment wardrobe,” King observes. “Even after this year’s downturn, US equities carry a notable premium, trading at forward P/Es 50% higher than non-US stocks.”

This situation leaves the US vulnerable to capital outflows, influenced by the attractiveness of overseas investment opportunities and President Trump’s strategies. Ironically, if the president’s tenure continues as it has begun, the US will need to rely more on improved economic fundamentals to gain buying momentum.

The S&P 500 has fallen about 10% since its peak in February. Yet, the steady flow of news makes it hard to determine what has been factored into the market.

With the ongoing barrage of policy announcements, exceptions, delays, and rejections, investors reassess risks daily, adjusting their perspectives compared to the previous day. This consequently alters the criteria used to evaluate growth and profitability estimates.

Despite the chaos, the market appears to remain positioned for a positive result. Stocks are currently not even set up to absorb a minor downturn. “For the S&P 500 to reach the current consensus, Trump would need to promptly reverse tariffs,” believes Berezin.

While recent concessions indicate the president can be somewhat flexible, the extent and timing remain uncertain. If most investors anticipate tariff rates to eventually stabilize at significantly higher levels under Trump compared to where they were initially in 2025, they have not fully accounted for this expectation or the persistent economic uncertainty.

Wall Street’s earnings and growth expectations are likely to drop further. As this happens, markets may also start to critically evaluate the narratives surrounding AI and US exceptionalism. This is why I worry that the S&P 500 might finish the year not with a 5 handle, or even a 6, but with a 4.

Feel free to send your thoughts, reflections, and year-end S&P 500 predictions to freelunch@ft.com or on X @tejparikh90.

Something to Consider

Thinking about taking a break from social media? A recent study on deactivating Facebook and Instagram accounts prior to the 2020 US election showed improvements in users’ happiness, depression, and anxiety levels.