Market Commentary

• The long-term “average” price-to-earnings (P/E) ratio we hear the financial media frequently quote is not an apples to apples comparison.
• Today’s S&P 500 Index (SPX) is built around high-quality, high-growth companies that have been producing strong revenue and earnings streams.

The SPX isn’t as expensive as it might look. But how can one make that statement when the P/E ratio (the price per dollar of earnings investors are willing to pay for an individual stock or equity index) is trading at 25x our estimate ($270) for this year and 22.5x our 2026 estimate ($300)? We are not going to make the argument that stocks are cheap; they aren’t. But the 16x – 17x long-term “average” we hear the financial media frequently quote is not an apples to apples comparison when looking at the current makeup of the index. Let’s investigate further.

But let’s get something out of the way first. To begin, and perhaps most importantly, using the P/E ratio is not a reliable gauge to time when to buy or sell. Stock markets that look expensive on a P/E basis can keep going higher. Investors certainly want to keep an eye on valuations but should use a gauge such as the P/E as just one arrow in their quiver.

In the U.S., it is not unusual for new disruptive technologies that are in the early stages of their development to attract large amounts of investor capital. Think back over the past 125-plus years to railroads, then automobiles, and more recently, the internet, and now artificial intelligence (AI). All of these past technologies carried high valuations early in their development periods as investors tried to anticipate the potential magnitude of eventual adoption. AI shares that feature.

A meaningful factor to consider when looking at P/E valuations and historical comparisons is the makeup of the SPX. The Information Technology sector made up only around 10% of the total capitalization of the index in the 1970s but has climbed to more than 35% today per Bloomberg data. When you add the mega-capitalizations of a small number of tech-like companies in the Communications Services and Consumer Discretionary sectors, these high-growth companies make up more than 40% of the total value of the SPX. Today’s SPX is built around high-quality, high-growth companies that have been producing strong revenue and earnings streams relative to the more established slower-growth industrial companies that dominated the index in decades past. Higher-growth companies typically carry higher-than-average P/Es.

A different twist on valuation comes if one looks at the S&P 500 equal-weighted index (SPW). All companies have an equal weight in this index. Remember, the SPX is a capitalization-weighted index, so more highly and mega-valued companies have a bigger influence on the movement of the underlying index. Based on Bloomberg data, the P/E on the SPW now stands at a much more reasonable 18.9x. That means there are areas of the market that are more reasonably valued.

So, how do we use valuation? We rebalance (take profits) in sectors that look overextended (as we did in downgrading the Communication Services sector earlier this year). And we look for different, less costly angles from which to play the AI trend. So, in this case, we favor the Information Technology sector for direct AI exposure but also the Industrials and Utilities sectors that will build the AI infrastructure and power the data centers. And we can look for other trends to diversify exposure. We are also most favorable the Financials sector as we believe falling short-term rates and steady-to-higher longer-term rates are a positive.

Forecasts, estimates, and projections are not guaranteed and are based on certain assumptions and views of market and economic conditions which are subject to change.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets.

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. Investing in the Financial services companies will subject an investment to adverse economic or regulatory occurrences affecting the sector. There is increased risk investing in the Industrials sector. The industries within the sector can be significantly affected by general market and economic conditions, competition, technological innovation, legislation and government regulations, among other things, all of which can significantly affect a portfolio’s performance. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market. Utilities are sensitive to changes in interest rates, and the securities within the sector can be volatile and may underperform in a slow economy.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

S&P 500 Equal Weight Index is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight - or 0.2% of the index total at each quarterly rebalance.

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