The US stock market has become extremely expensive, but the silver lining is that it can easily stay this way for a long time.
$S&P 500 Index (.SPX.US)$It has rebounded nearly 30% from its October low. In recent months, the index has continued to rise, driven by big tech companies.$NVIDIA (NVDA.US)$The latest rise in stock prices also played a role. Nvidia shares rose another 10% on Thursday May 23 due to earnings growth exceeding market expectations. Big tech companies themselves are also vigorously promoting product improvements and reaping additional profits from the advent of artificial intelligence.
Furthermore, even as inflation cools, the economy continues to grow and drive non-tech stocks higher. This means that the Federal Reserve may not need to raise interest rates any further, which would maintain demand for goods and services.
Currently, the price-earnings ratio of the S&P 500 is close to 21 times analysts' expectations of total earnings for the next 12 months. According to our calculation of FactSet data, this price-earnings ratio almost reached its highest level since the end of 2021, surpassing the 20-year average price-earnings ratio of 15.9. But a higher-than-average valuation isn't necessarily wrong — as long as interest rates are lower, this will increase the value of future cash profits.
However, the yield on 10-year US Treasury bonds is not low. Currently, it is 4.4%, which is only a few percentage points lower than the highest level in decades. This means that the stock's valuation “should” be closer to their long-term average, but quite the opposite, they are much higher.
The key word here is “should” because the reality is that valuations are likely to remain at a high level.
First, the most expensive stocks, the shares of big tech companies, account for an unusually large share of the index. The high-tech industry has a market capitalization of trillions of dollars. In addition to Nvidia, there are$Apple (AAPL.US)$,$Microsoft (MSFT.US)$,$Meta Platforms (META.US)$,$Amazon (AMZN.US)$,$Alphabet-A (GOOGL.US)$, and even chip makers$Broadcom (AVGO.US)$und$Advanced Micro Devices (AMD.US)$, and software giants $Salesforce (CRM.US)$.
According to Truist data, the market capitalization of the entire high-tech industry accounts for about 30% of the total market value of the S&P 500 Index, which is probably the largest weight since the early 2000s. As a result, this sector contributed greatly to boosting the index's overall price-earnings ratio.
This means that as long as these companies reach their valuation levels, the S&P 500 index will remain high. According to FactSet, analysts' total earnings for the tech industry are expected to grow 16% each year this year and next, which is roughly double the growth expected for all non-tech industries over the same period. The above companies are expected to maintain double-digit growth rates for the next few years until after next year.
Another factor supporting valuation is that currently large amounts of capital are regularly flowing into the market through passive equity funds. Passive funds are funds that buy multiple stocks and hold them for a long time, such as mutual funds and ETF funds that copy the S&P 500 index. In contrast to this, active fund managers can trade stocks as they please through active investment tools.
According to Truist data, passive funds currently account for about 60% of the net assets of all equity funds in the US, up from 4% in the early 90s of the last century. They have become cheaper for people, increasing people's chances of entering the market, which means that capital is constantly pouring into the market and keeping stock prices high.
Truist Co-Chief Investment Officer Keith Lerner (Keith Lerner) wrote in a report: “Considering the significant growth in 401 (k) funds and index funds, the cost of entering the market in the form of lower trading commissions is lower, and buyers are less price sensitive... This indicates that the company's valuation premium has increased compared to historical levels.” He added that regardless of market valuations, people's wage checks will fund their 401 (k) plans.
At the end of the day, there are several factors that prompted investors to pay a premium for holding the S&P 500 index. Some are based on fundamentals, while others are rooted in how money flows today. For cautious investors, the key question is how long big tech companies can maintain rapid growth. Profit growth is likely to change — it may slow down — but the way people invest is likely to continue.
As long as big tech companies maintain rapid growth, the S&P 500 index will remain high.
Editor/Jeffrey