Equities have become priced to perfection recently, fueled by bank and tech earnings that have exceeded expectations even as industries like autos that are affected by new trade policies have lagged.
The lofty equity valuations have come after the economy appears to have eased to a growth rate of 1% or just above in the first half of the year.
It’s a dichotomy that raises a question: Are equity valuations disconnected from economic fundamentals and the condition of the real economy?
To answer this question, we look at the equity markets in the post-financial crisis era, with the now tech-heavy S&P 500 increasing at an average annual rate of 12.1% from January 2010 to June 2025.
Share prices in equity markets ostensibly reflect corporate earnings. Earnings per share in the S&P 500 increased at a 9% annual rate over the same time, while the small-cap Russell 2000 index increased by 8.7%.
By removing the S&P 500 from the picture, it appears that the Russell 2000 valuations are not as distant from nominal gross domestic product and corporate profits.
The one big difference between the two indices are the major tech stocks inside the S&P 500, which have soared into a universe of their own.
In addition, the money supply grew at a 6.4% yearly rate, corporate profits grew by 5.9% while nominal GDP grew at a 4.7% average annual rate.
The takeaway
In the era of near-zero interest rates after the financial crisis, and then during the pandemic, the equity market logically became the market of choice for investors,
The performance of the S&P 500 is dominated by large tech stocks. The small cap Russell 2000, which might better reflect the real economy, has likewise benefited from the strength of the tech sector.
There is a widening gap between equity market performance and economic growth, similar to the second phase of the personal computing revolution in the 1990s, when productivity soared.
Today, equity investors are anticipating a similar surge in productivity, and valuations, with the arrival of artificial intelligence. But should this buoyant view fall even just a little short, there is risk that equity valuations will need to adjust lower, reflecting the fundamental condition of the real economy.
