Think the S&P 500 Looks Cheap? Read the Fine Print
The index’s P/E ratio depends on who is defining the ‘E’
By Jonathan Weil, The Wall Street Journal, July 13, 2026
Wall Street pros are predicting stellar S&P 500 earnings growth this year and beyond. But there’s a problem with the underlying numbers. They are often deeply distorted…
If you pick an “E” that uses actual net income for the past four quarters, the index may seem pricey at about 29 times earnings.
More commonly, though, Wall Street analysts steer investors to some form of alternative earnings. Viewed this way, the index may trade for around 22 times earnings using analysts’ 2026 estimates, except the adjustments that analysts make routinely ignore regular, real-world expenses such as stock-based pay or restructuring costs…
Many Wall Street analysts don’t calculate GAAP earnings projections, even when asked explicitly for them in survey forms. So the consensus forecasts become a hodgepodge of estimates, with some tracking net income and some using earnings before bad stuff…
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The rest of the article compares earnings growth forecasts provided by various analysts using GAAP and non-GAAP numbers. It’s confusing because it’s a hodge podge of different methods.
Wall Street analysts and major index providers often favor operating earnings (pro-forma or “headline” earnings), which intentionally strip out “one-time” or “unusual” costs.
The Valuation Gap: Because operating earnings exclude bad news like massive write-offs, aggregate operating earnings for the S&P 500 are almost always higher than as-reported earnings.
The “Fine Print”: If a valuation model uses operating earnings, the market will appear cheaper (lower P/E ratio) than if it uses Shiller’s stricter as-reported earnings.
Leaving out depreciation from earnings has a dramatic impact on AI. The chips are run 24/7 at high temperatures that physically wear out the microscopic solder points. The attrition is tremendous - about 1/4 are fried in 3 years. But the hyperscaler companies are depreciating the chips over 5 years instead of their physical life expectancy of 3 years. This makes non-GAAP earnings billions of dollars higher.
I prefer to look at the CAPE, the cyclically adjusted price-to-earnings ratio.
Cyclically adjusted price-to-earnings ratio - Wikipedia.
Using average earnings over the last decade helps to smooth out the impact of business cycles and other events and gives a better picture of a company’s sustainable earning power.
But many investors invest in the S&P 500 Index. The S&P 500 is a constantly-changing index that is selected by a committee at Standard & Poors. New, growing companies are added continually and failing ones weeded out.
The continuous rotation of companies within the S&P 500 introduces a structural phenomenon that systematically biases the long-term CAPE ratio upward, making modern stock markets appear more expensive relative to historical averages than they might actually be. The rotation ensures that the CAPE ratio will almost always flash an “overvalued” warning signal during prolonged periods of economic innovation and growth. The fastest-growing companies may not have had significant earnings in the past 10 years before their most recent growth. The fastest-growing companies may not have had significant earnings in the past 10 years before their most recent growth so their CAPE (10 year average) looks high.
Is the S&P500 in a bubble despite the earnings forecasts for 2026-2027?
Most of the earnings comes from within a circular “AI ecosystem.” Real end-users are only about 15% of the earnings. Earnings estimates are really based on building the AI infrastructure. Gemini calculates that the end-user spending will break even with investments around 2035. That’s assuming a very high growth rate of end-user spending from the current level of 30% to 35% CAGR – ignoring the more typical S-shaped curve of initial rapid adoption followed by plateau.
If the deep-pocketed hyperscalers like Microsoft, Alphabet, Amazon and Meta realize this and begin to slow down their spending the entire ecosystem share prices will crater. Everything is priced for perfection. That doesn’t even count cheaper or more advanced technologies from China already in the works to make up for the embargo of the most advanced chips.
Wendy
