Thus far in 2024, the U.S. economy has surprised to the downside.  This is illustrated by the Bloomberg U.S. Economic Surprise Index, which has fallen steadily since June 2023 and entered negative territory this past March.

But the U.S. stock market, as measured by the S&P 500 Index, has done the opposite.  It had delivered a healthy return of 9.6% through August 5th—despite the recent sharp pullback..

While this disconnect between stock prices and economic momentum isn’t unheard of, it certainly isn’t the typical pattern.  It may have led investors to conclude that U.S. stocks are too expensive.

By some key measures, U.S. stock valuations do appear quite high.  As of August 5th, the forward price-to-earnings ratio, or P/E, for the S&P 500 stood at 19.7 times earnings, significantly higher than its 25-year average of 16.4.  

The U.S. market also looks expensive when compared to other regions of the world.  As of late July, forward P/Es for the MSCI Europe, Japan, and Emerging Markets indexes were all significantly lower than for the S&P 500.

A closer look, however, reveals that the S&P 500 valuation has been distorted by a handful of mega-cap technology stocks that have heavy weights in the index.  Known as the “Magnificent Seven,” this group includes Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla.  As of late July, these seven stocks accounted for over 31% of S&P 500 market capitalization.  

The Magnificant Seven have P/E ratios that are considerably higher than the rest of the S&P 500.  On a cap-weighted basis, the forward P/E for the Magnificent Seven was 27.8 times earnings as of August 5–versus just 17.5 for the rest of the stocks in the index. A P/E of 17.5 is still somewhat elevated relative to S&P 500 history, but considerably below both the Magnficant Seven and the index as a whole.  

The overall sector mix within the S&P 500 is another factor that has pushed index valuation higher. This mix has changed dramatically over the last 25 years. Notably, the information technology sector has become an increasingly large share of the index, and accounted for 32% of S&P 500 market cap as of the end of June.

Meanwhile, the financials and energy sectors both have steadily lost ground within the index. Together they now account for only 16% of S&P 500 market cap. 

This is notable because, like the Magnificant Seven, technology stocks in general tend to be more expensive than financials and energy stocks.  The 25-year average forward P/E for the S&P 500 technology sector is 21 times, but is just 12.8 for financials and 14.4 for energy.  So, comparing the current S&P 500 P/E with its historical average is not really an apples-to-apples comparison.

This can also help explain why there has been such a disconnect between U.S. economic data and the S&P 500 Index.  While the U.S. economy may be experiencing a cooling-off period, earnings in the technology sector have remained very strong, thanks to a massive infrastructure buildout for artificial intelligence, or AI, over the past few years.

So, how can we account for the outsized influence of tech stocks on S&P 500 valuation? This is a difficult question to answer and typically requires deep fundamental analysis.  But when evaluating individual companies, one simple sanity check for an unusually high valuation is to compare the P/E to the company’s return on equity, or ROE—a measure of how profitable and efficient it has been over the past year. This same analysis can be applied to the S&P 500.

When we make that comparison, we find that the very high P/Es for the Magnificent Seven and broader tech sector are accompanied by similarly high ROEs. 

As of August 5th, ROE was 37.7% for the Magnificent Seven and 31.5% for the S&P tech sector as a whole versus just 16.3% for the rest of the index. Likewise, comparisons with other major regional markets find a similar relationship, with key indexes for Europe, Japan, and the emerging markets all showing dramatically lower ROEs than the S&P 500 along with their lower valuations.

The bottom line is that elevated valuations for U.S. technology stocks collectively, and for U.S. stocks in general, do not appear unreasonable when viewed in this context.  The real question is whether the levels of profitability and efficiency that U.S. tech companies have exhibited collectively can be sustained.

Undoubtedly, this question will hinge on the growth trajectory for AI. During the current infrastructure buildout, companies have been willing to commit large capital expenditures to AI initiatives without substantial evidence that these investments will be sufficiently profitable.  Eventually, that evidence will need to emerge. 

While U.S. stocks may seem overvalued on the surface, a deeper analysis shows that these elevated valuations have been driven by exceptional profitability. But the sustainability of those profit levels remains an open question. As a result, our Asset Allocation Committee currently holds a broadly neutral allocation to U.S. equities.