Is the Stock Market Overvalued? What Investors Can Do

The last few years have been a good time for U.S. equity investors. After returning 26% in 2023 and 25% in 2024, the S&P 500 continues to rise and is up 14% thus far in 2025. But lately, people are questioning if we’re in another stock market bubble just waiting to burst.

After this period of significant market appreciation, it’s fair for investors to ask if the market is overvalued. Many turn to price-to-earnings (P/E) ratios to gauge market valuation. This ratio indicates how much investors are willing to pay for each dollar of earnings, helping them assess if the market is undervalued, overvalued, or fairly valued.

As you can see in the chart below, the S&P 500 appears to be overvalued and is trading at a significant (more than one standard deviation) premium to its 25-year average. This is also true over longer time periods. While several arguments can be made around why a valuation premium may be justified—high profit margins, earnings growth, the future benefits of artificial intelligence, the Federal Reserve cutting rates—the data says that the market is currently overvalued.

Source: FactSet, Cerity Partners, 9/30/2025

Does the stock market being overvalued matter?

Perhaps the more important question investors should be asking is whether this overvaluation matters. Is analysis of the market’s current valuation useful when predicting its future direction? In our estimation, while the current valuation level of the market may provide a helpful long-term signal, it matters little in the short to intermediate term. Here’s why:

• The market can stay overvalued or undervalued for a long time before normalizing, and being too early when timing a correction can be immensely expensive and painful.
• Looking simply at valuation levels relative to historical norms is a flawed tactic.
• Ultimately, we can conclude that valuation is most useful to investors as a signpost but should not be used as a roadmap. It can tell us where we are and give us an idea of what the terrain looks like, but it may not tell us where we are going or when we will get there.

Valuation cycles

Valuation cycles tend to be many years long, with broad variation in length. Even the best market historians can’t tell us where we are in a cycle until after the cycle has ended. Much of the work in market valuation analysis is predicated on the expectation that valuations will revert to the mean. But the truth is that these metrics are of limited use as a practical market-timing tool.

Consider the case of Japan during the 1980s, when valuations crept above normal levels in 1981 (giving what might be considered a bearish signal of overvaluation) and then skyrocketed as market P/E levels rose from 30 to 50 and beyond along with a rising market. The end result was that Japanese stocks stayed overvalued for nearly a decade.

Source: “Were Japanese stock prices too high?” Kenneth R. French and James M. Poterba. Massachusetts Institute of Technology, June 1991.

Using extremes to predict

Previous cycles’ most extreme valuation levels may prove to be poor predictors of this cycle’s highs or lows. Dividend yields for domestic stocks have been lower in recent history than in the past because payouts have declined in favor of other tools to return capital to shareholders, such as buybacks. Historically dividend yields below 3% were quite uncommon, and when they did occur, subsequent market returns were quite poor.

Consider the extremes shown in the graph below. During the 1900s, dividend yields fell near or below 3% several times: in 1929, before the stock market crashed; in 1961, followed by a period of below-average market returns; and in 1987, followed by another crash. How many investors in 1992, seeing yields fall below that tried-and-true 3% level, assumed wrongly that prices were set to fall again and cause dividend yields to rise back above 3%? In contrast, we now know that over the next five years stocks returned over 20% per year and that dividend yields have since only been near 3% quite briefly during the extremes of the 2008–2009 financial meltdown. The example of dividend yields clearly demonstrates why investors should exercise caution in using previous cycles’ highs and lows as guides for the future.

Source: Investopedia, “A History of the S&P 500 Dividend Yield”

Valuations are a signpost, not a roadmap

If we can’t use valuation for market timing, then what other indicators might be informative? We find it’s most helpful to look at the underlying fundamentals, such as drivers of future economic growth and future inflation, as well as investor sentiment. Valuation analysis may still be helpful to forecasters because it can give us a sense of when these other market forecasting indicators are most likely to be successful.

When the market is under- or overvalued, shorter-term signals like investor sentiment become more important and fundamentals become less important. As valuations get higher and higher (or lower and lower), the market starts to trade heavily on emotion and investors are increasingly likely to overlook the fundamentals. In these situations the fundamentals, while always of key importance at the end of the day, may be less helpful for short- or intermediate-term timing.

Currently, we remain positive on the U.S. economy. Despite numerous reasons for caution—valuations, inflation, the labor market, government policy, and more—the market continues to “climb the wall of worry” and deliver excellent returns. Corporate earnings have been strong, and S&P 500 earnings growth is estimated to finish 2025 at 12% and increase to 14% in 2026, both above historical averages (Bloomberg yearly/calendarized earnings estimates as of November 21, 2025). It is certainly possible that longer-term future earnings growth is high and the market will grow into its valuation. At the end of the day, while the current market looks expensive, there’s no reason it can’t get more expensive.

What should you do when the stock market is overvalued?

Knowing the market is overvalued, what’s an investor to do? Simply put, stay the course. While it’s inevitable that markets will correct at some point, for now we recommend staying diversified, rebalancing as appropriate, and sticking with your long-term asset allocation plan. If you have any questions, reach out to your Cerity Partners advisor or request an introduction today.