Last week, the S&P 500 made another new all-time high, its 53rd of the year so far. US stocks are up nearly 30% year-to-date, which comes on the heels of a strong 2023, in which US stocks returned +26%. US markets are also doing well on a relative basis, broadly outperforming most other asset classes, including foreign developed stocks, emerging markets, and real estate. Despite higher interest rates, elevated inflation, and a volatile election season, these past 24 months have been among the best of times for US equity holders.
However, alongside the new record highs, a new concern is growing — as prices continue to climb, some measures of stock market valuations are starting to look stretched. In fact, most conventional price ratios seem to show a US stock market that is at or near the upper limits of historical ranges. For example, the ratio of Price to Sales for the S&P 500 is well above the peak levels of 1999/2000 and approaching the record highs of 2021.
At 27.5, the price/earnings ratio for the S&P 500 is also nearing peak levels. Frothy-looking valuations are beginning to worry some investors, although as evidence-based investors, we know that valuations provide no actionable insights as to the near-term direction of equity markets. In other words, an “expensive” looking market can continue climbing higher for months or even years. But still the question remains – can we say that US stocks are, in fact, “expensive”?
A Market of Stocks
Before answering that question, we should remember that the “stock market” is a market of stocks, each with their own characteristics. For capitalization-weighted indexes like the S&P 500, the very largest “mega-cap” companies in the index have an outsized influence on aggregate market statistics, including returns. Today, the largest ten companies in the S&P 500 comprise more than 1/3 of the weight of the entire index. This measure of index concentration is itself at an all-time high and reveals how dominant large technology companies have become in the market and the economy. Compared to a decade ago, investors are paying far more for these shares (on a dollar per unit of sales or earnings basis) than for other companies in the index. The willingness by investors to pay such high multiples for a handful of companies is what is driving the overall index valuation ratios ever higher. The next table, showing the change in P/E ratios over the past ten years, illustrates this point:
While P/E ratios have risen across all US large company classes, the change since 2014 is most pronounced in US large growth companies. And while US large companies have grown more expensive relative to earnings, this has not been the case among small US companies. In fact, P/E ratios have actually fallen over the past 10 years for US small cap stocks. The decline in P/E multiples is particularly striking for US small cap value stocks.
Outside of the US, there is also no sign of exuberant valuations. Price/earnings ratios for foreign developed stocks are unchanged in the past ten years and up only slightly among emerging market stocks.
By segmenting the market into these various subclasses, a clearer picture of the current state of valuations emerges. While valuations do look elevated in the US, this is mainly a function of: (1) historically high multiples on US large growth (tech) companies; and (2) a record high weighting on those kinds of companies in the S&P 500 index. Notably, outside of US large growth, wide swaths of the world equity market appear reasonably priced today. For investors concerned about current market prices and their implications for future returns, the argument for diversification has never been stronger.
Sources:
https://www.avantisinvestors.com/avantis-insights/what-todays-valuations-are-telling-investors
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