Testing the Bull Run: Can the S&P 500's 10% Rally Defy Elevated Valuations?

The S&P 500's relentless climb toward all-time highs has sparked debates over whether BMO Capital's 11% rally prediction—a call for the index to hit 6,700 by year-end—can materialize amid historically high valuations and lingering macroeconomic risks. While bullish forecasts cite supportive Federal Reserve policies, earnings momentum, and cyclical tailwinds, skeptics highlight the S&P 500's elevated price-to-earnings ratios and the fragility of past rate-cut-driven rallies. This analysis dissects the validity of BMO's outlook through three lenses: macroeconomic drivers, valuation metrics, and historical precedents.

Macroeconomic Drivers: Fed Easing and Earnings Broadening

BMO's bullish case hinges on three pillars:
1. Federal Reserve Policy: The Fed's 2024 rate-cut cycle, which reduced the federal funds rate to 3.25%-3.5%, has injected liquidity into equity markets. Historically, rate cuts have been a catalyst for risk-on sentiment, with the S&P 500 averaging 14.1% gains in the 12 months following the first cut (see table below). BMO anticipates further easing in 2025, arguing that subdued inflation and a soft-landing scenario will sustain accommodative conditions.

1. Earnings Growth Momentum: BMO's chief strategist Brian Belski emphasizes a “broadening-out effect,” where mid- and small-cap stocks (SMID caps) and value sectors (e.g., industrials, energy) begin contributing meaningfully to S&P 500 gains. This shift reduces reliance on mega-cap tech names, which have dominated returns for over a decade. However, SMID caps remain vulnerable to macro volatility, as their valuations are less insulated than those of tech giants.

2. Pro-Growth Policies: While not explicitly stated, BMO's forecast assumes that Trump-era policies—tax cuts, deregulation, and infrastructure spending—will bolster corporate profitability. Yet, the administration's track record on trade and immigration remains a wildcard. Past “TACO” (Trump Always Chickens Out) dynamics—where markets shrugged off policy threats—may persist, but protectionism could still disrupt supply chains or labor markets.

Valuation Metrics: Overvaluation or Overdue?

The S&P 500's valuation metrics paint a cautionary picture. As of June 2025, the Shiller Price-to-Earnings (CAPE) ratio—a long-term valuation measure—stood at 35.0, nearly double its 20-year average of 17.5 and 80% above its 150-year median of 16. This implies the market is significantly overvalued relative to historical norms. The metric's implied annual return under mean reversion assumptions is just 2.4%, suggesting limited upside unless earnings growth outpaces expectations.

Critics argue that the CAPE's focus on 10-year earnings averages may understate the current environment's uniqueness. For instance, the rise of AI-driven productivity gains and structural shifts in corporate profit margins could justify higher valuations. Conversely, a recession or policy misstep could trigger a sharp reversion.

Historical Precedents: Rate Cuts and Bulls

BMO's optimism aligns with historical patterns. Since 1929, the S&P 500 has delivered positive returns 86% of the time in the 12 months following a rate cut cycle. Notable examples include:
- 1982: Fed cuts amid a recession led to a 36.5% surge in the S&P 500 as Reagan-era fiscal stimulus and tech innovation fueled recovery.
- 1998: Rate cuts during the Asian financial crisis and Long-Term Capital Management meltdown coincided with a 27.3% rise, driven by the dot-com boom.
- 2019: Post-rate cuts, the S&P 500 rose 14.5% in 12 months, buoyed by fiscal stimulus and global trade optimism.

However, exceptions like the 2001 dot-com bust and 2007 housing crash highlight risks. In both cases, rate cuts failed to offset structural economic flaws, leading to declines of 13% and 49%, respectively.

Synthesis: Can the Rally Hold?

BMO's prediction requires three conditions to hold:
1. Earnings Broadening: SMID caps and value sectors must outperform, reducing reliance on FAANG-like stocks. Recent data shows SMID caps are up 12% year-to-date, but this outperformance is fragile in volatile markets.
2. Fed Policy Consistency: Rate cuts must proceed without inflation flaring up. The Fed's credibility is at risk if core PCE inflation exceeds 3% in late 2025.
3. Policy Uncertainty Mitigation: Trade disputes or immigration crackdowns must not disrupt supply chains or labor markets.

Investment Considerations

The S&P 500's ascent to 6,700 is plausible—but investors should proceed with caution:
- Bullish Play: Overweight cyclical sectors (industrials, financials) and SMID caps if earnings momentum holds.
- Risk Management: Use index options (e.g., S&P 500 puts) to hedge against a CAPE-driven correction.
- Valuation Discipline: Avoid overpaying for growth. Focus on companies with Buffett-Munger-like qualities (strong balance sheets, consistent earnings).

The market's current premium valuation suggests a “buy the dip” strategy is riskier than in 2023. Investors should prioritize quality over momentum and maintain cash reserves for potential volatility.

In conclusion, BMO's 10% rally prediction is not irrational—historical cycles and macro tailwinds provide a foundation. Yet, the S&P 500's elevated CAPE ratio and sector concentration mean this rally is more fragile than past bull markets. Success hinges on whether earnings growth and policy stability can outweigh valuation headwinds. For now, the path to 6,700 is open—but it's paved with uncertainties.