How expensive is the S & P 500? One common argument is the S & P 500 will have trouble advancing in the fall because the P/E ratio is too high. On the surface, it sure seems rich. The benchmark is currently trading at 19.8 times forward earnings estimates (forward earnings encompasses earnings for the next four quarters: Q3 and Q4 of 2023, and Q1 and Q2 of 2024). That is well above the 10-year average of 17.6, according to Refinitiv. “The forward P/E is high, and the market is fully pricing in expected forward growth, as the risk-reward tradeoff appears to solidly be in the risk category,” Howard Silverblatt, senior index analyst at S & P Global, told me. But look below the surface, and much of the S & P is not overvalued. The issue is, are there any bargains left? A small group of big cap tech stocks are lifting the multiple Everyone knows that the so-called “Magnificent 7 ( Apple , Amazon , Alphabet , Microsoft , Nvidia , Tesla , Meta ) are responsible for a large part of the gains in the S & P 500 this year. They’re also a big reason the multiple is so high. Take them out, and the multiple contracts to close to its historic norm (around 17). S & P 500 Current multiple: 19.8 Ex-Magnificent-7: 17.3 Ex-Technology: 17.8 Source: Refinitiv Biggest winners this year have multiples far above their norms No surprise here. Technology, Communication Services, and Consumer Discretionary have had huge gains this year: Sector leaders this year Technology +46% Communication Services +44% Consumer Discretionary +34% Those sectors are also sporting outsized multiples. Technology, for example, is trading at 28 times forward earnings, which is 45% above its historic norm of 19. S & P 500 Sectors (Forward P/E, with % above 10-year average) Technology: 28.0 45% Consumer Discretionary 27.5 23% Communication Services 15.6 11% Source: Refinitiv Again, much of this is due to the influence of the “Magnificent 7”: Apple, Microsoft, Nvidia in the technology sector, Tesla and Amazon in consumer discretionary, Meta and Alphabet in communication services. Most other sectors are only slightly above, and several are trading at or well below their historic norms, including financials, utilities, real estate and energy. S & P 500 Sectors (Forward P/E, with % above/below 10-year average) Materials 17.8 6% above Industrials 18.9 7% above Consumer Staples 19.9 3% above Health Care 17.3 8% above Financials 13.2 0% Utilities 17.1 3% below Real Estate 36.0 14% below Energy 11.1 53% below Does this mean that the market is a bargain? Unfortunately, no. “It would appear that many sectors are fairly-valued (six sectors within +/ 10% of long-term average) which [was] not the case during the height of the pandemic,” Tajinder Dhillon, senior research analyst at Refinitiv, told me. In plain English: the overall market was a real bargain at the height of the pandemic. It isn’t anymore. Parts of it are overvalued (Technology and Consumer Discretionary), but most of the S & P can be categorized as “fairly valued” with some pieces (Real Estate and Energy) still undervalued. Of course, it is a market of stocks. Dhillon points out that more than half of the stocks in the S & P 500 are trading below their historic P/E average and below the S & P’s historic average. That would imply there is some value still to be found in the markets. But it’s tough. What could remedy this situation? So what has to happen? First, earnings had better start rising, and fast. That is exactly what the market is anticipating, a U-shaped recovery in earnings, with estimates that put Q2 2024 estimates 15% above Q2 2023: S & P 500 (earnings, dollar estimates) Q1: $53.08 Q2: $52.72 Q3: $55.72 Q4: $57.50 Q1 24: $57.43 Q2 24: $60.15 Source: Refinitiv Second, revenues need to keep growing. Revenues are lower in Q2 than in the same period last year, and are only expected to grow in the low single digits for the next year. “Higher revenues enable companies to keep spending,” Silverblatt told me. “That means more hiring, more capital expenditures, more ability to pay dividends and [make] buybacks. When revenues stagnate, companies start cost-cutting.” Given how much the consumer has been spending, that’s a tall order. “It’s a lot to put on the consumer,” Silverblatt said. What does this all mean? It means that if you own the S & P 500 or other broad index funds, you are not getting paid much to own stocks at current prices. With the yield on 2-year Treasuries near 5%, the market is saying the premium to own (risky) stocks over (risk-free) Treasuries is pretty small. That leaves stocks vulnerable to sudden downturns. That’s why you hear people say, “I wish the market would drop 5% so I could buy more.” It means don’t be surprised if we suddenly see an air pocket in August, when the market is suddenly down 5% in a week or two.
