Here's something funny about Wall Street right now: Almost every strategist agrees that earnings are going up. Their forecasts for S&P 500 earnings in 2026 cluster around $300 to $320 per share, which translates to solid year-over-year growth of 11% to 19% from where we expect to land this year.

But ask them about valuations, and you'll get a completely different response depending on who's talking. The forward price-earnings ratio is hovering near five-year highs, and strategists are split right down the middle on what that means.

Some argue the elevated forward P/E is perfectly justified and should stay elevated, which would help deliver above-average market returns in 2026. Others see it as a headwind, warning that the high multiple will likely drift back toward its long-term average and limit returns in the process.

If you're someone who believes valuations revert to their historical means (a theory that's actually been challenged plenty), you probably lean toward that more cautious view. Maybe this time they'll be proven right.

Market Truth: Valuations Are Terrible at Predicting Next Year's Returns

Here's the thing about P/E ratios. They can tell you whether stocks look cheap or expensive compared to history. What they can't tell you is what's going to happen over the next 12 months.

Schwab's Liz Ann Sonders and Kevin Gordon illustrated this brilliantly in their 2025 outlook report. They plotted one-year returns on the S&P 500 against various forward P/E levels going back to 1958, and the result is pretty eye-opening.

"You can see that the relationship is a very weak -0.12 — essentially insignificant," Sonders and Gordon wrote. "It underscores the important market truth that valuation is a horrible market-timing tool (as if a good timing tool even exists)."

The chart looks like complete chaos. Sure, there are times when a 22x forward P/E preceded negative returns. But there are just as many instances where that same valuation level preceded really positive returns. The relationship is basically noise.

Three Things Worth Remembering

First, look at where most of those dots fall. The overwhelming majority sit on the positive side of the chart, which reminds us that stocks usually go up. This holds true even during periods when P/E ratios are elevated.

Why does this happen? Because earnings and expectations for earnings are typically rising, and earnings drive stock prices over the long term. Much of this year's market rally can be explained by earnings estimates moving higher even as P/E ratios stayed relatively flat.

Second, falling valuations don't automatically mean falling prices. Stocks can rise while valuations compress, as long as earnings grow faster than the multiple contracts. It's simple math, but people forget it all the time.

Third, the correlation between valuations and returns does get stronger when you extend the time horizon beyond one year. But even then, the relationship isn't perfect. It's better than nothing, but it's hardly a crystal ball.

None of this means forward P/E ratios are completely worthless when you're thinking about portfolio adjustments. They have their place in the toolkit.

But it's worth remembering that markets do unlikely and arguably irrational things over short periods all the time. If you're counting on valuations to guide your near-term decisions, you might want to lower your expectations about how useful they'll actually be.