A new record high for US stocks, but mind the lopsided valuations

Despite recessions and other economic fallout from the Covid-19 pandemic, the benchmark S&P 500 index recovered all of its lost ground this year to close at a new record high this week. Investors are right to ask if US equities are now overvalued: the index’s price-to-earnings ratio hovers around 27 times 1-year forward earnings, which is a decade high and far above long-term averages. But dig deeper and the picture is more nuanced, as the narrow rally in shares of tech giants belies more reasonable valuations elsewhere. 

The five biggest tech giants with over US$400 billion market cap  (Apple, Amazon, Microsoft, Facebook and Alphabet) continue to lead this rally and dominate the S&P 500. Their combined market cap is around US$7 trillion and as a group now represent 23 per cent of the index based on market capitalisation, the biggest share in modern times for the top five. The tech titans also have the richest average PE ratio, at 44 times earnings. This significantly skews the entire index’s PE ratio.

But dig a little deeper and a different picture starts to emerge. If we exclude the tech giants, the weighted average PE ratio of the remaining 495 index constituents is 22 times earnings. Still high, but much more reasonable. However, there is more to it than that.

The market is putting a significant premium on earnings growth. This is clear when we compare today’s estimates for 1-year earnings versus 2019 earnings. The weighted average growth in earnings 1 year from today is expected to be 41 per cent higher than 2019 earnings for the top 5 largest companies, whereas it is essentially flat for the rest of the index.

So, the message from the market is that the top 5 companies can keep driving growth while the rest of the index companies lag. We think this implies ample room for a broadening of the rally, but it is difficult to see that happening without a better macro outlook leading to a more widespread improvement in earnings forecasts.

These lopsided expectations undermine the argument that the rally has been driven by falling real yields. In fact, the sectors usually most sensitive to falling interest rates, like utilities and REITs, have lagged. Investors seem more focused on a company’s ability to grow profits in the post-Covid ‘new normal’, and we think this will continue to be the main driver of market returns over the medium term.