By Tim Courtney, Chief Investment Officer
Recent data from Standard and Poors shows that the S&P 500's price-to-earnings (P/E) ratio is sitting near 24 as of the end of January, about 30% higher than the 18.5 we've seen on average over the last 20 years.1 That number was at 17.6 as recently as late 2022 so, simply put, the index has gotten pricier.
When looking at statistics like P/E, you might get the impression the data is representative of the average stock in the index. However, it's not that straightforward when we start to peel back the layers of the S&P 500. Because the S&P 500 is a market cap weighted index, and because the index is currently more concentrated in its top names than ever before, a handful of names is driving this relatively high P/E.2 Many of those names are AI-related in the tech or communications sectors.
However, when you remove those big players from the mix, the remaining companies paint a different picture. When reducing the impact of the Magnificent Seven companies – Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla and Meta – as the S&P 500 Equal Weighted Index does, we have an index P/E ratio of 19, which is closer to historical averages.3 The average stock in the index doesn’t appear overly expensive.
Of course, the average stock is also not growing as fast as many of the above companies. But growing larger and faster has its own challenges. It becomes more difficult for the largest companies to continue producing break-neck growth year, after year, after year, which is what some of these companies need to do to justify their current pricing.
This situation brings us back to a basic investing principle: the price you pay for an asset is the largest determinant of your future returns. The higher the price you pay today, the lower your future expected returns are. As investors, we must be cognizant of the price we are paying and future cash flows since these will determine our expected future return.
Valuations for a handful of companies have been moving higher faster than their earnings have, and this is despite elevated interest rate levels. This market behavior is a change from what we have seen over the last few years. In 2021, prices surged with rates at historic lows, then dropped in 2022 as interest rates moved higher. Prices rose in 2023 at least partially based on the hope that rates would fall and, in 2024, prices are moving higher even though the hope for rate cuts has faded.
While the overall market (US large, US small/mid, international) appears to be reasonably valued, pockets of the market have seen price increases that have outstripped their earnings growth. The market is pricing some of these companies as if their current growth will continue for decades. History shows it is unlikely to happen. If you have questions, please contact your Exencial advisor.
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Price-to-Earnings (P/E) Ratio is a stock valuation metric comparing a company's share price relative to its earnings per share (EPS). The ratio helps to assess the relative value of a company's stock.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
The S&P 500® Equal Weight Index (EWI) is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight - or 0.2% of the index total at each quarterly rebalance.