The record-breaking close in the U.S. stock market last week brought valuations back to their highs from July of the previous year. However, Citigroup's strategists suggest that upon closer examination, U.S. stocks may not be as expensive as they appear.

Citigroup's strategists, led by Scott Chronert, stated in a report on January 19th that despite the S&P 500 index reaching historic highs last Friday, pushing the forward price-to-earnings ratio of the benchmark above 20, this deviation is primarily driven by what they call the "Tech Seven" in the U.S. stock market.

"Valuation is a common headwind to our optimistic S&P 500 outlook," the team wrote. "In our view, index P/E ratios may be misleading."

The rise of companies such as Apple, Microsoft, Nvidia, Alphabet Inc., Amazon, Meta Platforms Inc., and Tesla has fueled the market recovery, driven largely by optimism about artificial intelligence and cost-cutting measures by these companies. The S&P 500 equal-weighted index, which removes the excessive impact of these companies, has a forward P/E ratio of around 16, which is 17% lower than the benchmark's standard valuation.

According to Chronert and his team, the influence of mega-cap tech stocks distorts the true picture. These strategists mentioned that about 60% of the constituents of the S&P 500 index are measured by P/E ratios, while 40% use other metrics. They believe that the current underlying valuation distribution is closer to a P/E ratio of 19, rather than significantly above 20.

"One key takeaway is that more S&P 500 constituents can re-rate," said Chronert. "This supports our evolving argument that we are focusing on adding cyclicals to the portfolio rather than defensives while maintaining exposure to growth."

The strategists also pointed out that valuation setups are not always signals of future performance but should be seen as a reflection of future growth expectations. They stated that although a pullback may occur after a significant rise in the last quarter, it provides opportunities for buying on dips.

The team forecasts that the S&P 500 index will reach around 5,100 points by the end of the year, approximately 5.4% higher than the closing level last Friday.