Is the S&P 500 Rally Driven by Fundamentals or Speculation?
The S&P 500 climbed above the 7,600 mark for the first time this week, extending its powerful rally that has been largely fueled by enthusiasm surrounding artificial intelligence. The milestone has reignited a key debate among investors: is the market’s rise supported by genuine earnings growth, or is it being driven primarily by speculation?
According to Capital Economics, the answer depends largely on the valuation method being used.
Two Valuation Models, Two Different Conclusions
John Higgins, Chief Economic Adviser at Capital Economics, noted that the two most widely used valuation frameworks paint very different pictures of the current market environment.
When measured using forward 12-month earnings per share (EPS), the rally appears to be fundamentally supported. Under this approach, earnings growth has accounted for a larger portion of the S&P 500’s gains since the end of 2022 than valuation expansion, indicating that improving corporate profitability has been a major driver of the market’s advance.
Forward Earnings Suggest Strong Fundamentals
The forward earnings model focuses on expected future profits and suggests that companies have delivered enough earnings growth to justify much of the recent rally.
As forward EPS has increased significantly over the past several years, the market’s price-to-forward-earnings ratio has remained relatively contained. This implies that investors have not simply been paying higher prices for the same level of earnings, but rather have been responding to stronger profit expectations.
CAPE Analysis Points to Speculation
However, a different conclusion emerges when using the cyclically adjusted price-to-earnings ratio, commonly known as the CAPE ratio.
Capital Economics examined the inflation-adjusted rise in the S&P 500 using Nobel Prize-winning economist Robert Shiller’s widely followed valuation metric. Under this framework, the majority of the index’s gains since late 2022 appear to have been driven by multiple expansion rather than earnings growth.
According to Higgins, this suggests that speculative behavior has played a much larger role in the market’s rally.
Why the Results Differ
The gap between the two conclusions stems from the way earnings are measured.
Forward earnings estimates have grown rapidly, helping keep traditional valuation multiples relatively stable. In contrast, real trailing earnings have increased at a slower pace, causing the CAPE ratio to move significantly higher.
Capital Economics noted that the CAPE ratio has increased by nearly 13 points since the end of 2022, compared with roughly four points for the forward price-to-earnings multiple. This discrepancy helps explain why one valuation method points to fundamentals while the other highlights speculation.
The Final Verdict
Ultimately, Capital Economics believes there is no simple answer to whether the S&P 500 rally is fundamentally driven or speculative.
Investors focusing on future earnings growth may conclude that the market’s gains are justified by improving corporate performance. Those relying on longer-term valuation measures such as the CAPE ratio may argue that optimism and investor sentiment have been the primary catalysts.
As Higgins summarized, whether the S&P 500’s remarkable surge is driven by fundamentals or speculation depends entirely on the lens through which it is viewed.
