Hopes of a soft landing, expectations for higher earnings and lower real interest rates have driven stock valuations to their highest levels in months and near levels last seen in early 2022.

The S&P 500's daily forward price-to-earnings ratio, a measure of the index's relative value based on forecast earnings, settled at 20.75x on Jan. 24, up from the most recent low of 17.78x on Oct. 27, 2023, when the ongoing rally in large cap equities began.

The index's price-to-earnings (P/E) ratio is now at its highest level since late July and could soon reach its highest level since early 2022. The P/E ratio for the S&P 500 peaked at 22.37x on Jan. 5, 2022, about two months before the Federal Reserve began hiking interest rates in its push against skyrocketing inflation.

"I believe it's a combination of lower real interest rates and optimism about a soft landing that has driven valuations higher this year," said Michael Crook, chief investment officer at Mill Creek Capital Advisors. "The market has basically priced in lower real interest rates and these valuations are at risk if real interest rates don't fall from here."

Valuations are rising as investors increasingly believe inflation growth can fall to the Fed's 2% goal without triggering a recession, said Craig Erlam, a senior market analyst at OANDA.

"It appears to be an increasing hope of a fairy tale end to the inflation crisis of the last couple of years," Erlam said. "For a long time, a soft landing appeared to be that. Now investors are sensing it could be even better."

Mega-caps drive gains

Much of the rise in valuations has been within the S&P 500's largest companies, particularly the five mega-cap tech stocks that have partly carried the ongoing rally.

While the S&P 500 is up about 21.2% over the past year, the S&P 500 equal weight index, where all companies are given the same fixed weight, is up less than 4.3%.

"The S&P 500 is skewed by the largest stocks," said Matt Peron, director of research and global head of solutions at Janus Henderson Investors.

Promise, risk ahead

As the domestic economy continues to strengthen, a recession is avoided, inflation falls and the Fed, potentially, begins to cut interest rates, valuations could rise further.

"Valuations are rising because there is widespread acceptance that rates have peaked and will be coming down," said Paul Schatz, president of Heritage Capital.

Yet lower rates could pose a risk to valuations, Schatz said, pointing out that stocks collapsed when the Fed began cutting rates in January 2001 and July 2007.

"Be careful what you wish for," Schatz said.