You have likely heard us discuss valuations ad nauseam over the past few months as we continue to see record highs established in many of the top names within the S&P 500 and Nasdaq.

It is during these periods of market optimism that investors often face a familiar dilemma: are elevated valuations a sign of sustainable strength or a warning flag of speculative excess?

As we navigate a late-cycle environment characterized by elevated equity multiples, persistent liquidity, and moderating inflation pressures, it’s important to separate valuation justified by fundamentals from valuation driven primarily by sentiment and momentum.

This separation, while challenging, is critical to try and avoid pockets of irrational exuberance (to steal a line from former FOMC Chairman Alan Greenspan).

The Case for Justifiable High Valuations

At their core, stock prices reflect the present value of expected future cash flows.

When earnings visibility, balance-sheet quality, and profitability improve, higher valuations can be warranted even if multiples expand.

This has been particularly true in recent years across sectors like technology, healthcare, and consumer services — areas where companies have demonstrated structural advantages in growth, efficiency, and pricing power.

Factors That Can Make Elevated Valuations Rational‍

Sustained earnings growth and high returns on capital:

Firms with expanding free cash flow (FCF), resilient margins, and strong return on invested capital (ROIC) can support higher price-to-earnings (P/E) or price-to-free cash flow multiples. In these cases, valuations reflect the durability of future cash flows, not mere enthusiasm.‍

Innovation and market leadership:

When companies operate in sectors with expanding addressable markets (e.g., artificial intelligence, digital infrastructure, advanced manufacturing), markets often price in future dominance. If that growth is backed by high reinvestment returns and clear competitive moats, higher valuations can be justified.‍

Falling discount rates:

When interest rates decline — as they typically do during or following a Fed rate-cutting cycle — the discount rate applied to future earnings falls. This mathematically increases the present value of future cash flows and can explain multiple expansion without signaling overheating.‍

Improved macro visibility:

A stabilization in inflation and policy clarity often compresses risk premiums, allowing investors to accept slightly higher valuations as compensation for a more predictable macro environment.

We are seeing stabilization in inflation, but there are still some uncertainties in the policy side of the house. We do, however, believe that the chaos in the realm of policy will likely calm down as the Trump administration continues to push forward with their agenda(s).

In such contexts, paying a “quality premium” can be a disciplined decision. High-quality companies — those with consistent FCF generation, capital discipline, and sustainable competitive advantages — often maintain premium valuations through cycles and deliver better long-term risk-adjusted returns.

When High Valuations Become a Warning Signal

Not all multiple expansion is grounded in fundamentals.

Markets can periodically shift from confidence to complacency, where investors extrapolate near-term strength too far into the future.

Warning Signs of Overheating

‍Earnings growth decouples from price action:‍

When multiples expand despite slowing or declining earnings revisions, markets may be fueled more by liquidity and momentum than by fundamentals.‍

Compression in risk premiums:‍

If investors demand less compensation for risk despite macro uncertainty, it can lead to inflated asset prices vulnerable to reversion when volatility returns.‍

Speculative participation and narrow leadership:‍

Concentration in a handful of high-multiple stocks can mask underlying weakness in broader market breadth. When leadership narrows and valuation dispersion widens, it often precedes short-term corrections.‍

Fading productivity or margin trends:‍

If high valuations persist as cost pressures rise or productivity gains flatten, it may reflect optimism unsupported by cash-flow growth.

In these cases, elevated valuations can signal overheating, particularly when combined with accommodative financial conditions and complacent investor sentiment.

History shows that multiple compression often follows periods where valuations disconnect from earnings momentum or cost-of-capital realities.

This is a situation where the proverb often cited by Warren Buffett holds true:

“Pigs get fat, hogs get slaughtered.”

This is a cautionary tale about the dangers of excessive greed, especially in investing, and it shows that it is important to focus on the underlying fundamentals and not rely solely on market euphoria and momentum.

Finding Balance — Fundamentals First

For investors, the key is not avoiding high valuations altogether but differentiating between quality-driven premium pricing and speculative excess.

This requires a disciplined focus on metrics such as ROIC, FCF yield, revenue durability, and balance-sheet leverage — alongside broader macro indicators like credit spreads and earnings revisions.

Within our multiple diversified strategies, we continue to emphasize companies with fundamental support for their valuations: resilient earnings, pricing power, conservative leverage, and management teams deploying capital effectively.

While some sectors may appear expensive, there are likely many high-quality businesses that remain relatively attractive when viewed through a long-term cash-flow lens.

While periods of elevated valuations are not inherently negative, they do require greater selectivity and a willingness to rebalance when market optimism stretches beyond earnings potential.

As always, fundamentals, not headlines, remain the best guide to distinguishing sustainable value creation from fleeting momentum.

We discuss our rigorous 5-step due diligence model frequently, and it is critical during periods of perceived “lofty valuations.”

Your Financial Peace of Mind is our primary objective, and we will continually monitor the U.S. and global economies and markets and take appropriate actions if/when we believe there is a divergence in the valuation and fundamentals of the holdings in our various strategies.

As always, we hope that you have a wonderful fall season and look forward to seeing you again soon.