King S&P

. – Barron’s

  By Guest Blogger Sinan Terzioglu

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The S&P 500 index is up over 7.5% and has made several new record all-time highs so far in 2024. Over the past decade, thi index has consistently outperformed international equities returning an average total return of approximately 12.50% per year. Investors are increasingly wondering if the strong performance can continue.

I was recently asked:

“I’m worried about the US market being at an all-time high and I’m wondering whether I should sell my US positions? The S&P 500 has become so concentrated with a handful of stocks making up a large percentage of the index. Also, the price-to-earnings ratio is high relative to its historical average as well as international markets. With all the hype about AI and the big run up in stocks like NVIDIA, I’m worried the US market has gotten too far ahead of fundamentals like it did during the technology bubble in the early 2000s.”

A good question. Investors should always be assessing their holdings, valuations and risks.

According to data from JPMorgan, the S&P 500 has risen by an average of 14% one year after setting a new all-time high. After 3 years, it has risen by an average of more than 50% and after 5 years, it has jumped an average of approximately 80%. If history’s any guide, you should not be concerned just because the S&P 500 is at or near an all-time high.

Over the last 10 years the S&P 500 has become increasingly more concentrated. The top 10 holdings currently make up approximately one-third of the index. In 2015, the top 10 comprised less than 20% of the index.

Ben Carlson, writer of the blog Wealth of Common Sense, highlighted that it’s important to keep in mind that concentration in the markets is not new and has been cyclical over time. Throughout the 1950s and 1960s, the top 10 stocks regularly made up approximately one-third of the total market cap of the S&P.  In the late 1960s and early 1970s, the top 10 were over 40% of the index and dropped to below 20% by the end of the 1980s before rising to around 30% in the early 2000s.

Carlson pointed out concentration is the norm in markets around the globe. He shared the following table showing the top 10 holdings of every G7 country using MSCI country stock market ETFs to compare the weights in the S&P 500:

Source: Wealth of Comon Sense

So it’s common for a small number of large companies to make up a large portion of a stock market but it doesn’t mean it’s something investors do not need to pay attention to. For example, prior to its collapse, Nortel Networks represented over 30% of the S&P/TSX Composite in July 2020.

Are current market valuation too high?

The current valuation of the S&P 500 stands at slightly above 20 times estimated forward earnings, representing a premium compared to both the 5-year average of 19 and the 10-year average of 17.70. Additionally, over the last 10+ years, the price-earnings ratio of the S&P has expanded relative to international markets, so it’s important to understand the reasons.

Mike Hickey, a portfolio manager at Fidelity Investments, released a research note recently comparing US stocks to non-US stocks. Based only on valuation metrics such as price-earnings (P/E) multiples, he says, is too simplistic and ignores the drivers behind the long-term profit advantages of the companies in the US market. Rather than just comparing P/E multiples, investors should be studying whether profit advantages in the US are likely to persist.

Hickey’s note highlighted the importance of return on equity (ROE), which is a gauge of a corporation’s profitability and how efficiently it generates those profits. ROE is just one measure of profitability but one that the world’s most famous investor, Warren Buffett, pays close attention to. The higher the ROE, the better a company is at converting its equity into profits.

Over the last 10 years, Hickey noted approximately 35% of stocks in the S&P 500 with above average ROEs (20% to 70%) outperformed the index and returned an average of 13.70% per year.  Looking at non-US stocks in the MSCI EAFE index, Hickey noted that 19% of the index had ROEs of between 20% to 70%, and this group returned an average of 8.25% per year over the last 10 years.

Hickey’s key takeaway was that the ROE advantage for US stocks has a good chance of continuing because the S&P 500 has more companies in high-margin sectors with capital-light structures. Additionally, these companies have relative inflation resistance and engage in more frequent share buybacks as well as dividends increases. When taking ROE into account, the S&P 500 may not be as expensive compared to non-US stocks.

At the peak of the tech bubble in the early 2000’s, valuations for technology stocks were significantly higher than the rest of the general market. Today, valuations for technology stocks are higher than the general market but they are nowhere near levels seen during the early 2000’s. So while the S&P 500’s valuation has moved higher over the years, it has done so for good reason. Bank of America’s Savita Subramanian put it well in a recent interview:

“The S&P 500 is half as levered, is higher quality and has lower earnings volatility than prior decades. The index gradually shifted from 70% asset-intensive manufacturing, financials and real estate companies in 1980 to 50% asset-light Tech & Health Care. We’re in a different ball game here so you can’t just look at the S&P today and take that P/E and compare it over time.”

The US remains dominant in global productivity and is likely to continue to be the birthplace of many innovative and fast growing companies for the foreseeable future. The S&P 500 will likely not continue to consistently outperform international equity markets every year, but there’s a strong likelihood that a high percentage of companies in the S&P 500 will maintain their return on equity (ROE) advantage for many years to come, leading to returns over the long run similar to those seen in the past several decades.

To mitigate risk effectively, long term investors should continue to have an allocation of US equities as part of a well-balanced and diversified portfolio.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.