Are U.S. stocks too expensive?
The S&P 500 Index is sharply higher this year, having posted seven consecutive monthly gains through the end of August while notching 53 record highs along the way. Index-level earnings have also eclipsed their pre-pandemic highs with record growth; however, the price-to-earnings (P/E) ratio remains above long-term averages. As a result, some investors are questioning the relative attractiveness of U.S. equities.
It’s reasonable to question the risk-return profile of domestic stocks when comparing current valuations with long-term averages. While we don’t believe stocks appear cheap at current valuation levels, our analysis of the changing dynamics of the U.S. economy and market structure suggests a comparison with historical averages may not tell the whole story.
The U.S. economic transition from manufacturing to services
The U.S.’ transition from a manufacturing-based to a more services-oriented economy began in earnest after World War II but accelerated over the past several decades (Figure 1) due in large part to the exponential growth and adoption of technology. A secondary catalyst has been the shift in demographics — particularly the baby boomer generation. As we discuss below, these structural shifts have had important implications for U.S. equity markets.
Technology sector underpins valuation increase
The economic shift to a more service-based economy has led to meaningful changes in the relative weights of the GICS1 sectors that comprise the S&P 500 Index. This is important because the sectors and companies most impacted tend to have above-average profit margins and earnings growth; characteristics for which investors are willing to pay a premium.
The U.S. has been — and remains — the global leader in technological innovation, and the services that companies in the Technology sector provide generate the highest gross margins of any sector2 and have consistently generated above-average earnings growth. Since the start of the post-Financial Crisis bull market in the second quarter of 2009, the Technology sector has produced annualized earnings growth of 16.2% compared to the broader index’s 11.7%3. And companies that generate above-average earnings growth command higher valuation multiples, which in turn increases the market capitalization-weight of the companies in the index. The Technology sector’s weight increased from just over 6% in 1990 to nearly 30% this year despite some of the largest companies in the world getting re-characterized as Communication Services firms in 2018 when MSCI changed the composition of the GICS sectors; Alphabet (Google parent) and Facebook among them.
Looking below the sector level, breaking down the current GICS industry-level composition of the S&P 500 Index’s P/E ratio (Figure 2) illustrates that four of the top five contributors are within the Technology sector. Including the Interactive Media & Services, along with Internet & Direct Marketing Retail — both of which are comprised of firms commonly associated with technology — combine to account for nearly 40% of the P/E composition.
Interest rates may be the most important structural change in terms of its impact to equity valuations. Over the past 40 years, long-term interest rates have been in a sustained downtrend, as shown in Figure 3. Comparing this to the rolling 10-year average P/E shows that rates have fundamentally changed the time value of money calculation. When determining the current value of a company’s stock, investors first attempt to forecast the firm’s future earnings. There are various methods used in this process, but the future earnings stream must be discounted to arrive at the estimated present value of those earnings, (i.e. stock price). This adjustment accounts for the opportunity cost of foregoing current income for expected future payments.
In other words, money received today has a greater value than money received at some point in the future. The old bird-in-hand analogy. And using a lower interest rate to discount future earnings equates to a higher present value since money invested at lower rates would earn less than it would if interest rates were higher, all else equal. Consequently, the opportunity cost is lower when interest rates are lower. This is important because the 10-year Treasury yield is a commonly used discount rate, and that yield has steadily declined from a high of 15.32% in 1981 to its current range between 1-2%. We do not expect it to move materially higher for the foreseeable future.
Structurally lower interest rates have also influenced investor behavior by encouraging capital flows into riskier assets; including stocks. The situation has become more pronounced in recent years as the baby boomer generation — the largest in U.S. history — began to retire. In retiree’s search for replacement income amid an interest rate environment well below levels seen during their accumulation phase, many have been forced to bear additional portfolio risk to increase expected return. Interest rates are likely to remain low for the foreseeable future, and the last of the baby boomer generation will not reach age 65 until 2030. Consequently, we expect demand for stocks to remain elevated, further supporting valuations.
Those who underweighted or avoided U.S. stocks over the past several years on the basis of elevated valuations, though seemingly justified, would have left significant money on the table. Stock valuations are indeed above long-term averages, but changes in the structural composition of the U.S. economy, the nature of the firms that have benefitted most from it, and steadily declining interest rates that appear likely to remain in low suggest to us that a new normal is in place. Furthermore, corporate America has proven resilient in its ability to sustain healthy earnings growth, including a strong bounce-back from the pandemic.
We do believe rates will trend modestly higher from current levels; however, we also expect corporate earnings growth to meet or exceed any rate increases. Consequently, we expect stocks will be able to maintain current valuation levels while still providing upside potential. Using historical data to inform current investment decisions is part of the process, and we do not suggest investors ignore it. We do, however, recommend that investors not use stock valuation levels as a reason for straying from their long-term asset allocation targets.
2 Source: Dow Jones
3 Source: Dow Jones
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