With U.S. stocks continually climbing to fresh records, some investors have latched onto fears that valuations are rising to levels that could warrant a correction.
But according to DataTrek co-founder Nicolas Colas, stocks today aren’t as overvalued as they look.
Traditional measures of valuation including price-to-earnings (PE) ratios do suggest the S&P 500 is trading above its recent historical averages. The S&P 500’s current forward P/E ratio is 18.6x, or well above the 10-year average of 15.0x. However, a combination of a low interest rate backdrop and shifting company composition of the blue-chip index today helps make the case for today’s rich valuations, Colas said in a note Wednesday.
First, interest rates have come down below their levels from the early 2010s, lowering the cost of borrowing for companies and giving them access to capital to grow their businesses at a cheaper price tag.
“From 2010-2013, when the S&P’s PE was reliably below 14.0x, the average yield of the 10-year Treasury was 2.51%,” Colas said. “Everyone remembers when yields were low in 2012, often below 2.0% due to the Greek debt crisis, but bookending that were yields closer to/over 3.0%.”
Today, the benchmark 10-year Treasury yield is hovering just over 1.6% and has not topped 2.0% since mid-2019.
“With corporate earnings stable in 2020 (i.e. no recession expected), valuations should be higher if discount rates are lower,” Colas said.
And second, more expensive valuations for the S&P 500 as a whole make more sense when considering the most heavily weighted sector is now technology, with high-growth companies in this sector tending to trade at higher multiples relative to corporates in other groups.
Case in point: Technology sector companies are trading at 22.5x 2020 earnings, Colas said, while components of the financial and health care sectors – the cheapest groups – are trading at 13.2x and 15.9x this year’s earnings, respectively.
“Look back at how the S&P sector weightings have evolved over the last decade and you get useful insight into why valuations are high just now,” Colas said.
“At the start of 2010, Technology was 18.7% of the S&P 500. On an apples-to-apples basis Tech is now 27.5% (with Google which is now Comm Services but was in Tech in 2010, but not Facebook because it was only added in 2013),” he added. “Throw in Facebook, and you get a 29.4% weighting today.”
That outsized weighting for tech companies has come at the expense of sectors that tend to be lower-growth and trade at lower valuations, including the energy, consumer staples, industrials and materials sectors.
“Bottom line: U.S. stocks are expensive, but for understandable and rational reasons,” Colas said.
Emily McCormick is a reporter for Yahoo Finance. Follow her on Twitter: @emily_mcck
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