We've closed the book on 2024, and it was a great year for the stock market. Overall, the S&P 500 advanced by about 25% -- making 2024 an above-average year.
Yet, that success does have a downside, and it could result in the biggest challenge for the stock market in 2025. Here's what it is.
Image source: Getty Images.
The S&P 500 is sporting a rich valuation as 2025 begins
Whatever goes up must come down -- or so the saying goes. And that could be the biggest challenge for the stock market right now.
Specifically, as of this writing, the S&P 500 sports a price-to-sales (P/S) ratio of 2.84x. That's the highest reading since 2021 and one of the highest readings on record.
S&P 500 P/S Ratio TTM data by YCharts
Indeed, going back to 2005, the average P/S ratio for the S&P 500 is around 1.79x. That means the current ratio is roughly 59% higher than the average.
What's more, valuations seem astronomical when compared to the S&P 500's average P/S ratio in the 20th century. For example, the S&P's P/S ratio remained below 1.0x for more than 25 years. Between 1969 and 1995, the S&P 500's P/S ratio average was about 0.66x -- reaching a low of 0.35x in 1982.
Granted, there are some structural reasons why investors are willing to pay more for stocks now than 40 years ago, such as the rise of individual retirement accounts at the expense of traditional pension plans. Nevertheless, given how high the stock market's valuation is today, some reversion toward the historical mean seems inevitable. So, what does history have to say about how that will happen?
Let's dig into that below.
How (and when) valuations fall
Since the P/S ratio is a ratio, there are two ways it can contract:
- The numerator (stock prices) can fall.
- The divisor (revenue) can rise.
While both of these methods would result in a lower ratio, in practice, only the numerator tends to bring down the ratio.
That's because rising revenue tends to result in increased optimism in the stock market. After all, investors are more likely to pour money into the stock market if companies are reporting better-than-expected sales.
On the other hand, pessimism brings stock prices down, even if revenue is holding steady or even increasing. That's easy to see during recessions. Take 2007 through 2009, for example. During this period, stock prices fell by more than 50%, leading to the S&P 500's P/S ratio dropping from a high of 1.52x in 2007 to a low of 0.80x in 2009.
S&P 500 P/S Ratio TTM data by YCharts
As 2025 gets started, there are economic concerns. For example, the incoming Trump administration plans to increase tariffs -- a measure that could stifle economic growth and cut into corporate earnings.
In addition, inflation remains slightly above the Federal Reserve's long-term goal of 2%. If inflation were to remain at that level or, even worse, climb, the Fed may need to shift gears and either halt its interest rate cuts or reverse them altogether and raise rates.
To sum up, the stock market's high valuation means that a correction shouldn't come as a surprise. In any event, the takeaway for investors is to focus on their long-term investment goals, which are best served by staying invested in the market through a diversified portfolio.
