This article was first published in the Globe and Mail on March 1, 2025. It is being republished with permission.

by Tom Bradley

There are always trends that take over investors’ consciousness. They’re expected to be important and permanent features of the stock market, but often turn out to be cyclical. When they’re booming, they’ll persist forever. When they’re busting, well, not so much.

My contrarian nature leads me to assume that everything is cyclical until proven otherwise. The pattern goes like this: When the latest and greatest get popular, demand increases and prices and profits go up. To take advantage of the opportunity, supply expands such that when demand slows, there’s a glut and prices weaken. Rinse and repeat.

Think back to the fibre-optic buildout in the early 2000s. It proved to be essential, but the outcome for participants was highly cyclical, and companies such as WorldCom and 360networks went bankrupt. The commodity boom a few years later, which was driven by China’s unquenchable thirst for resources, was expected to go on for decades but instead lasted a couple of years. And closer to home, who can forget the cannabis boom-and-bust.

My skepticism has served me well, but it isn’t foolproof. Indeed, my record (and confidence) has been tested by the sustained growth of companies such as Alphabet, Amazon, Apple, Meta, and Microsoft.

This cyclical-versus-sustainable debate is coming into play with stock valuations. I’ve read recently that above-average U.S. stock valuations are here to stay. Going forward, price-to-earnings multiples (P/Es) will be in the twenties instead of the teens, owing to higher corporate profit margins, an abundance of private capital looking to buy businesses and the dominance of the megatech companies.

It’s a theory that I can’t buy into. In my view, stock valuations fit firmly in the cyclical category. The factors claiming otherwise mostly point to reasons why P/Es expanded in the past two years, not why they’re going to stay elevated. Indeed, it could be argued that high profit margins are a reason for P/Es to decline. They make future gains (and growth) harder to achieve and ultimately attract increased competition. Nvidia is a current example. It’s growth and profits are prompting other companies to invest heavily in designing their own chips.

Stock valuations are driven by market narratives but anchored by economic reality. Narratives play to emotion and, as with anything emotional, cause the stock market’s volatility. Exciting trends like artificial intelligence push prices up for a time, just as gloomy outlooks and economic shocks lower what investors are willing to pay.

What doesn’t swing back and forth is the economics of owning a business. The price paid must reflect the potential rewards and risks (companies don’t always live up to expectations) and offer a reasonable payback. The return needs to be meaningfully higher than secure alternatives like GICs and bonds. Valuations pivot around this reality.

Returns come from three sources. First is the dividend. Second is profit growth, which makes the company more valuable over time. And third is any change in valuation from the time of purchase. If you buy a company at a 15 P/E multiple and sell it at 25, you’ve had a powerful tailwind at your back. If the numbers are reversed, the investment will be disappointing unless the growth component is enormous. Individual companies may be able to overcome such a headwind (think Nvidia), but profit growth for the market overall, which is tightly linked to the economy, is more pedestrian.

I’d be remiss if I didn’t mention the one factor that could cause P/Es to stay elevated. Interest rates are the biggest determinant of P/E levels. If inflation drops, and interest rates follow, future earnings are more valuable, and P/E’s will adjust accordingly. Be careful what you wish for, however, as near-zero rates are likely to come with a recession or crisis.

The cyclical-versus-sustainable distinction is important. If a company is cyclical, then high profitability and a high multiple is a deadly combination. When growth moderates and earnings estimates are reduced, the P/E applied to the lower numbers also shrinks. It’s a double whammy and helps explain why quality stocks can drop so precipitously when they fall out of favour, despite the companies continuing to do well.

If you’re paying a high P/E multiple, it should be for a stream of earnings that is expected to grow for many years to come. Don’t count on high market multiples to skate you onside.