"Expensive" is the new standard? Wall Street begins to accept the stock market valuation "new normal"

As market skeptics warn that stock market valuations have soared to dangerous heights, an increasingly vocal faction on Wall Street argues that it is time to reassess the definition of "expensive."

More and more Wall Street analysts suggest that investors may need to abandon their inherent perceptions of traditional price-to-earnings ratios. A strategist from Bank of America expressed a similar view last week, believing that the current high valuations should be seen as a "new normal," rather than expecting a mean reversion to the "lost era." Analysts point out that the valuation center of the S&P 500 index has structurally shifted upward, supported by multiple factors such as reduced recession risks in the U.S. economy, a transition to technology or service industries, and increased profit stability.

This echoes the recent analysis by veteran Wall Street strategist Jim Paulsen. Paulsen's analysis shows that the valuation center of the S&P 500 index has continuously moved upward over the past few decades, which he believes weakens the pessimistic rhetoric that directly compares the current artificial intelligence frenzy to the internet bubble of the late 1990s.

This shift raises two core questions: How should investors assess a continuously moving valuation target? Will it continue to enter "uncharted territory" at a similar pace? This debate about valuation paradigms is profoundly influencing investors' expectations for future market returns.

Structural Upward Shift in Valuation Center

Data shows that the valuation range of the U.S. stock market has undergone a significant leap this century. According to Jim Paulsen's analysis, the rolling average price-to-earnings ratio of the S&P 500 index has risen from about 14 times in the early 1990s to about 19.5 times today. In contrast, for nearly a century from 1900 to the mid-1990s, this ratio remained stable within a narrow range of 13.5 to 15.5 times.

Paulsen states:

"Valuations are undergoing some strange changes compared to the past—specifically, there is a persistent upward trend in the valuation range."

Paulsen believes that the upward shift in the valuation center is not coincidental and is supported by multiple factors. He points out that the frequency of recessions in the U.S. has significantly decreased, with the probability of occurrence dropping from about 42% before the war to only around 10% over the past 30 years. Additionally, the U.S. economy has transitioned from being industrially dominated to being led by technology and services, with the market itself increasingly favoring growth stocks that can support higher valuations.

Moreover, other structural changes have also played a role. The proliferation of electronic trading, along with increased participation from individual and international investors, has improved market liquidity. The permanent increase in what Paulsen calls "profit productivity" (i.e., the actual profits generated per unit of employment) has also provided an upward bias for valuations. Finally, the accelerating cycle of innovation throughout history has been another driving force behind rising valuations.

Changes in Component Stocks Support High Valuations

Paulsen is not the only market observer who believes that high valuations have their rationale. Strategists at Bank of America have also echoed this premise recently. Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America, wrote in a report to clients on September 24 that **the intrinsic attributes of the current S&P 500 component stocks support the expanding valuation multiples **

Subramanian pointed out that compared to the past few decades, companies in today's index have lower financial leverage, lower earnings volatility, higher efficiency, and more stable profit margins. She emphasized:

"The index has changed significantly compared to the 1980s, 1990s, and early 21st century. Perhaps we should consider today's valuation multiples as an anchor point for the new normal, rather than expecting mean reversion to a bygone era."

"Re-anchoring" instead of infinite rise

However, not everyone believes that valuations will continue to rise indefinitely. Jonathan Golub, Chief Equity Strategist at Seaport Research Partners, offered a more moderate view, arguing that the market is not in a state of 'valuation drifting upwards indefinitely,' but rather 're-anchoring at a higher level.'

Golub explained that the low valuations of the 1970s and 1980s were partly due to extremely high interest rates that raised the cost of capital and threatened corporate operating capabilities. He believes that if borrowing costs were to experience a similar sharp rise in the future, valuation multiples could revert to the average levels of decades ago. However, he added that such risks are not currently evident