S&P 500 Faces Valuation Squeeze Amid Market Shift

Investors watching the U.S. stock market in early 2026 are witnessing a rare and complex transformation, one that’s challenging long-held assumptions about how the S&P 500 behaves—and what drives its performance. According to a recent note from Bank of America, the S&P 500 remains statistically expensive on 18 of 20 valuation metrics, with four of those metrics sitting near record highs as of February 20, 2026. This comes despite recent market volatility that has left many wondering if the index’s lofty levels can be sustained. Bank of America’s analyst Savita Subramanian emphasized that the bank continues to expect earnings-driven multiple compression, a technical term for when a company’s stock price rises less quickly than its earnings, causing the price-to-earnings (PE) ratio to fall. In plain English: even if corporate profits keep growing, investors may not be willing to pay as much for each dollar of earnings as they have in recent years. The bank’s year-end 2026 target for the S&P 500 is 7,100—one of the lowest on Wall Street. But here’s the twist: BofA’s earnings forecast is actually “on the high end of the range (+14%),” which, paradoxically, implies significant PE compression. Subramanian clarified that this call isn’t based on a simple return to average valuations, but on “compelling fundamental and macro reasons for PEs to compress further—even in Tech.” Why the cautious tone? Subramanian and her team outlined five key drivers for lower multiples. First is what they call “disruption math,” where declines in prices typically lead to downgrades in earnings expectations. Second, there’s a looming “glut of issuance”—a wave of mega-IPOs (initial public offerings) threatening to expand the supply of equities. That’s not just a theoretical risk: when more shares flood the market, existing shares can lose value if demand doesn’t keep up. Third, history is on their side: strong earnings-per-share (EPS) years “saw PE multiple compression 66% of the time,” according to BofA’s analysis. Rounding out the list are rising asset intensity and higher leverage—two factors that make companies more vulnerable to economic shocks—and the potential for “index risk from private hiccups,” meaning trouble in the private markets could spill over into public equities. Perhaps the most striking development in 2026’s market story is the fate of software stocks. Once the darlings of the digital economy, software companies have become the year’s worst-performing industry, down 20 percent year-to-date as of February 20, 2026. According to BofA, valuations in the sector are at decade lows, driven in part by concerns over artificial intelligence (AI) and its disruptive potential. Even so, the sector still trades “~20% below the long-term average,” but remains at a slight premium to the broader index. BofA cautioned investors not to expect “a quick valuation snap back in software or in the S&P 500.” All of this is happening against a backdrop of a historic shift in the structure of the S&P 500 itself. As MarketWatch reported on February 19, 2026, the index is undergoing a transformation that could reshape how investors think about the stock market. For years, the S&P 500 and the Nasdaq composite were propelled higher by a handful of megacap stocks—think the biggest names in technology and consumer goods. Their outsize influence meant that the market-cap-weighted S&P 500 often outperformed its equal-weighted sibling, which gives each stock the same importance regardless of size. But that dynamic has started to shift. The benchmark S&P 500, the market-cap-weighted version, is now underperforming its equal-weighted counterpart by the widest margin at this point in the year since the early 1990s. That’s a big deal. It suggests that the gains in the market are no longer so concentrated in a few giants, and that smaller and mid-sized companies are having more of an impact on overall returns. For investors used to the dominance of the so-called “Magnificent Seven” or “FAANG” stocks, this marks a significant change in the market’s character. What’s behind this shift? One major factor is the Federal Reserve’s interest-rate policy in 2026. MarketWatch identified this as a potential disruptor of the equal-weighted S&P 500’s current outperformance. Higher interest rates tend to weigh more heavily on growth stocks, which make up much of the megacap cohort, while potentially benefiting value-oriented or cyclical stocks that are more prevalent in the equal-weighted index. If the Fed’s policy continues to evolve, it could further alter the balance between these two versions of the S&P 500, with implications for everything from retirement portfolios to institutional investment strategies. The interplay between valuation, earnings, and market structure is making 2026 a year of recalibration for investors. On one hand, the S&P 500’s high valuations suggest caution is warranted. On the other, the underlying earnings growth—at least by BofA’s projections—remains robust. But with multiple compression looming, even strong profits may not translate into the kind of stock price gains that investors have come to expect during the bull runs of the past decade. Meanwhile, software’s fall from grace has left many analysts scratching their heads. After years of soaring valuations and relentless optimism about the digital future, the sector is now grappling with skepticism over AI’s impact and broader questions about sustainable growth. BofA’s warning not to expect a quick bounce-back is a sobering reminder that market sentiment can shift quickly—and sometimes stays sour for longer than expected. For those looking for silver linings, the rise of the equal-weighted S&P 500 offers a glimmer of hope that the market is becoming less top-heavy and more inclusive of a wider range of companies. But as the Fed’s interest-rate decisions loom large, there’s no guarantee that this trend will persist. Investors will need to keep a close eye on both macroeconomic signals and company-level fundamentals as they navigate a market that’s in the midst of a significant transition. As February 2026 draws to a close, the U.S. stock market stands at a crossroads. The forces of valuation, earnings growth, sector rotation, and monetary policy are converging in ways that could redefine what it means to invest in America’s largest companies. Whether this leads to a new era of broader market participation or simply a period of heightened uncertainty remains to be seen. For now, one thing is clear: the old playbook may no longer apply, and investors will need to stay nimble as the story continues to unfold.