Transcript
Thus far in 2023, the US economy has proven quite resilient despite the headwind from higher rates. Although this resilience has led to a steady improvement in the earnings outlook for US stocks as the year has progressed, many investors remain concerned because they believe stock valuations—typically represented by the forward price-to-earnings ratio—are too expensive.
In fact, when one compares the current P/E of the S&P 500 to its historical averages, it does appear elevated. As of October 23rd the forward price-to-earnings ratio of the S&P 500 stood at 17.5x, which is somewhat higher than the 25-year average of 16.4x. While the difference is not substantial, many investors believe that an elevated P/E is very much unwarranted given the numerous headwinds the equity market currently faces.
US stocks also look expensive when compared to other regions of the world. For instance, the forward P/Es for the MSCI Europe, Japan, and Emerging Markets indices are all significantly lower than that of the S&P 500.
A closer look at valuations reveals that the elevated valuations of US stocks is mostly attributable to a handful of stocks that account for a very large share of the S&P 500 Index. This group of stocks has become known as the “Maginificent 7,” and it includes Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. As of October 23rd, these seven stocks accounted for over 28% of the S&P 500 Index.
And this group of stocks holds a P/E ratio that is considerably higher than the rest of the index. On a market cap-weighted basis, the Magnificent 7’s forward P/E was 27.4x as of October 23rd. Consequently, if we were to remove these seven stocks from the index, the S&P 500 P/E would be a relatively modest 15.4x. So we can conclude that US stocks are not broadly expensive; rather, the Maginicent 7 are.
Since we know that US stocks appear to be expensive primarily because of the Magnificent 7, the pertinent question becomes: Do these stocks deserve to be this expensive? This can be a very difficult question to answer—one that typically requires deep fundamental analysis. But one simple way to provide a sanity check is to compare the P/E of an index to its return on equity—a measure of how profitable and efficient a company has been over the past year.
When we make this comparison, we can see that the very high valuations that these companiess hold are accompanied by a similarly high ROE. As of October 23rd, the Magnificent 7’s ROE on a market cap-weighted basis was 32.6%, while the rest of the S&P 500 Index was 17.2%. And further comparisons to other regional equity indices show a similar relationship, with the MSCI Europe, Japan, and Emerging Markets indices all holding dramatically lower ROEs to go along with their lower valuations.
The bottom line is that the elevated valuations of the Magnificent 7 collectively and US stocks in general are not unreasonable when taken in context. The real question is whether or not the level of profitability and efficiency that these seven companies have exhibited can be sustained.
In conclusion, while US stocks may seem overvalued on the surface, a deeper analysis shows that this is driven only by a handful of companies whose valuation collectively may not be unreasonable. As a result, our Asset Allocation Committee currently holds a broadly neutral allocation to US equities despite elevated valuations amid an uncertain environment.
