Different Companies, Different Ratios

In a previous note I mentioned that index valuation is a terrible market timing tool but questions about the valuation of the S&P 500 keep coming up. For example, people will send me charts like these from JP Morgan’s Guide to the Markets and make the point that the price to earnings (P/E) ratio for the S&P 500 today is too high and they’re waiting for a better time to invest. 

While I love charts and historical data (probably more than most), I think Savita Subramanian, an equity strategist with Bank of America that I quoted during my seminar, makes an important point that puts these numbers in context:  

• “I think the one bear case that I hear a lot that I want to try to debunk is just the idea that the market is too expensive. Folks will take today’s S&P and compare it to 10 years ago, 20 years ago, 30 years ago, 40 years ago. I don’t think that makes sense because the market today is such a different animal… 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 and healthcare.” 
  
  - Interview on CNBC, February 28, 2024 [emphasis added] 

This is important because not every dollar of earnings is the same.  A company that is debt ridden, inconsistent, and built on a foundation of depreciating assets is going to trade at a lower multiple than a company with less debt, more consistency, and greater growth potential.  Expecting an index that is now heavily weighted to Apple, Microsoft, Google, and Amazon to trade at the same multiple as an index that was once heavily weighted to General Motors, General Electric, and Exxon seems like a stretch.

But as we have said before, relative index valuation is not a great market timing tool, and this explanation is just one of the more interesting reasons why.