By Martin Bakadakos; Compiled by Barron's
U.S. stock market valuations are significantly higher than those of other global markets, driven in part by growth expectations, the dominance of the tech sector, and the market's vast liquidity, a trend that is likely to continue. According to a report from Capital Economics, the high valuation premium investors are paying for U.S. stocks is largely justified. The largest investors continue to pile into the market's pricier stocks while shunning cheaper alternatives. This likely means the S&P 500 can extend its strong spring and summer rebound into the final months of the year. Even if traditional valuation metrics suggest that stock prices are already above levels supported by corporate profit growth expectations, the stock market is poised to continue its upward trend. "We believe that improving risk appetite, the resilience of the U.S. economy and continued progress in artificial intelligence technology itself will provide tailwinds for the technology sector for the remainder of 2025," said James Riley, senior market economist at Capital Economics. "In this context, it is hard to imagine anything that could detract from the earnings performance of the U.S. technology sector." Riley believes that the earnings growth of the technology sector and the huge weight of the largest stocks in the sector in the U.S. broad market indexes are key factors driving higher valuations in the U.S. domestic market. Taking the MSCI USA Index, which tracks approximately 544 stocks, as an example, Reilly noted that investors are currently paying the highest premium to own U.S. stocks compared to indices of 20 other countries in at least the past 25 years. The MSCI USA Index currently trades at a price-to-earnings ratio of about 23 times the expected earnings of its constituents over the next 12 months. This is roughly in line with the P/E ratio of the S&P 500, which closed at a record high of 6,501 on Thursday. The index has risen nearly 30% since Liberation Day, while expected earnings for the S&P 500 as a whole have risen only about 5% over the same period. LSEG's latest estimate pegs it at $283.34. Reilly said the larger overall size and liquidity of the U.S. market compared to overseas markets has attracted more inflows into passive investments, such as index funds. This has provided continued support for the market and explains some of the discrepancies. "Furthermore, the number of companies included in the index means that, all else being equal, investing in the MSCI USA Index offers higher diversification benefits than investing in indices from other regions," he wrote. Reilly said the high premium for U.S. assets likely reflects market confidence that corporate earnings will continue to grow beyond the 12-month benchmark typically used to value global stocks. "In other words, while it may appear that investors are paying a premium for U.S. assets, they may simply be willing to pay for superior long-term growth," he said. Recent data from Bank of America suggests this view may be supported. The bank's quantitative strategy team noted that, compared to the S&P 500, long-term investors hold a higher percentage of each of the five "Big Seven" tech stocks, with the exception of Apple and Tesla, than the benchmark. Similarly, these investors hold about 20% less of non-Big Seven stocks than the benchmark, even though these stocks trade at significantly lower price-to-earnings ratios than their larger peers, making them appear "cheaper." Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, believes investors favor technology and growth stocks because they're betting they're less vulnerable to tariffs and will perform better in an economic downturn. "While the earnings per share (EPS) growth gap between the Big Seven and the rest of the S&P 500 has narrowed compared to 2023, the Big Seven maintain their lead – not giving up their lead in future earnings expectations," she said in a report released Friday. "The gap is expected to reach a low point in 2026, but the Big Seven's advantage will widen slightly by 2027." Calvasina also noted that the MSCI USA Index has outperformed its European, Asian, and Australian counterparts since its post-Liberation Day holiday low in early April. Capital Economics' Reilly said the trend is likely to continue, even if investors continue to buy high to participate in the rally. "We expect the MSCI USA Index to continue to trade at a premium to most of its peers over the coming year, which should help U.S. stocks outperform other markets again over that period," he said.
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