US Strategy Weekly: Valuation Two Ways

The DJIA, S&P 500, and Nasdaq Composite index made record highs on October 28, 2025, and the Russell 2000 index hit a record high one day earlier, on October 27, 2025. Year to date, the gains in the broad indices are DJIA 12.2%, S&P 500 17.2%, Nasdaq Composite Index 23.4%, and Russell 2000 12.4%. And though the technology-heavy Nasdaq Composite is leading the stock market with a gain of 23.4%, the advance in the equity market has been broad based.

The confirming breadth of the market is also seen by the new all-time high recorded by the NYSE cumulative advance/decline line on October 27. So, as we shift into the three most favorable months of the year for equities, the technical picture of the equity market remains bullish. The only minor technical issue we have with the stock market is that NYSE daily volume has been below its 10-day average for six of the last trading sessions. One likes to see volume increase on rallies to new highs. Plus, our 25-day up/volume oscillator continues to languish in neutral territory. To confirm these new highs, it is necessary for the oscillator to move into overbought range for a minimum of five consecutive trading days. The last time this occurred was in July. See pages 10-11. The neutral reading in this indicator suggests that volume in declining stocks is equal to that in advancing stocks, a sign of churning.

The backdrop for the market is good. We believe the Fed will continue to lower interest rates this year and are expecting another 25-basis point cut this week. The Wall Street mantra of “don’t fight the Fed” has been a useful guide in the past since a dovish Fed has typically been bullish for stocks.

The fiscal backdrop for the economy, consumer, and equities is also good. The One Big Beautiful Bill, which allows for immediate depreciation of capital expenditures is stimulative to Corporate America and is particularly helpful to small businesses. Moreover, we expect the first half of 2026 will be positive for many households who will experience lower taxes due to an increase in the standard deduction, an increase in the child tax credit to $2,200 per child, no tax on tips and overtime, and a deduction of up to $10,000 for interest on an auto loan for a US-made vehicle. 

Equally important is the fact that each earnings season of the year has brought a multitude of positive surprises. According to LSEG IBES, as of October 28^th, with 180 of the S&P 500 companies reporting third quarter earnings, 86.7% exceeded analysts’ expectations. This is compared to the long-term average of 67%, and the prior 4-quarter average of 77%. Earnings are rising but so are equity prices, consequently valuation has been a hurdle. If we use the S&P Dow Jones consensus earnings forecasts for 2026 of $302.58 with the recent SPX close of 6890.89, we get a PE ratio of 22.8. This is high, but PE ratios and inflation tend to have an inverse relationship that has been a valuable tool. So, if we add 3% inflation to this PE, the result is 25.8, the highest since August 2022 and above the standard deviation range (see page 10).

However, this index is still below the 30 level seen at the peak of the market in early 2022. More importantly, bubble markets, like those seen in 1997 to 2000, drove this “PE plus inflation” index to 42 in March 2000. In other words, if one thinks the market is forming a bubble, it is too early to get too bearish.

Another way to value equities is to compare the S&P 500’s earnings yield to the 10-year Treasury yield. The 10-year Treasury yield is currently 3.99%. The S&P’s earnings yield is 4.4% based on 2026 earnings and 3.7% on 2025 earnings. Adding the 1.2% dividend yield creates a total earnings yield for equities of 4.9% (2025) or 5.6% (2026), relative to the Treasury bond. Either way, equities look undervalued to bonds, particularly if interest rates continue to fall. In short, the liquidity backdrop for equities remains bullish.

Headline CPI rose 0.3% in the month of September, according to the BLS, and this lifted the year-over-year increase in the index from 2.9% to 3.0%. Core CPI, which excludes food and energy, rose 0.2% in the month and increased 3% YOY, which was a decline from the 3.1% YOY seen in August. The broad energy index was a major factor in September’s headline increase since it jumped from 0.2% YOY in August to 2.8% YOY in September.

Food prices rose 3.1% YOY in September versus 3.2% YOY in August, but the meats, poultry, fish, and eggs index was significant with a 5.2% YOY rise. Note, however, that while both CPI and core CPI are well above the Fed’s target of 2% YOY, both remain below the long-term inflation average of 3.7%. See page 3.

The good news in the September report was the steady deceleration in service sector inflation. Note that the service sector is important since it represents nearly 64% of the CPI and the good news was that prices rose 3.6%, down from 3.8% in August. The index for owners’ equivalent rent, representing 26.2% of the CPI index, rose 3.8%, down from 4.0%. The problem areas were motor vehicle maintenance and repair up 7.7% YOY, tenants’ and household insurance up 7.5% YOY, used cars and trucks up 5.1% YOY, fuels and utilities up 5.8% YOY, and other goods and services up 4.1% YOY. See page 4.

The source of energy inflation is not coming from rising commodity prices, as is typical. The energy commodity index was minus 0.4% YOY in September, up from minus 6.2% YOY in August, but still declining. However, the CPI’s energy index was still up 2.8% YOY, up from 0.2% YOY a month earlier. One of the problems is utility (piped) gas service which rose 11.7% YOY, down from 13.8% YOY in August, but still high. Growing international demand is boosting natural gas prices, and 40% of US electricity generation comes from natural gas, according to the Institute for Energy Economics and Financial Analysis. But gas service prices are also affected by costs for pipeline maintenance and replacement, and regional demand and supply factors. Regional energy demand is also being distorted by AI infrastructure energy usage. This is a major issue. See page 5.

Households, particularly low income households, are negatively impacted by the rising cost of energy services. The household energy price index rose 6.2% in September, down from 7.4% YOY in August but still extremely high. Along with utility (piped) gas service, this index is heavily weighted by electricity, up 5.1% YOY and fuel oil, up 4.1% YOY, in September. The other burden on households is the 7.5% increase in tenants’ insurance and 4.1% increase in household furnishings and operations. See page 6.

Conference Board consumer confidence fell one point in October to 94.6, from an upwardly revised 95.6 in September. The present index was 129.3, up 1.7 from an upwardly revised 127.5, and the expectations index fell 2.9 to 71.5, from an upwardly revised 74.4. The second estimates for October’s University of Michigan sentiment indices were all lower. The headline index is now 53.6, down 1.5 from September. The present conditions index is 58.6, down 1.8 and the expectations index declined 1.4 to 50.3. The University of Michigan sentiment indices have been in recession territory for most of the last five years, which makes them irrelevant as a tool, in our opinion. See page 7.

Gail Dudack

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