The premium paid for U.S. stocks faces a test

Open this photo in gallery:

For a quality product, consumers can usually justify paying a premium. So it is for investors and the S&P 500 index.

Shares in the U.S. stock market benchmark have long traded at a premium to global peers but the trend has been reinforced by the steady transformation of the index toward technology-orientated companies that are growing quickly and are very profitable.

“The S&P 500 is a digital index and these businesses have a proven ability to grow economic profits,” says David Bianco, chief investment officer, Americas, at asset management firm DWS Group GmbH & Co. in New York.

He estimates that 45 per cent of the S&P 500 is digital, in the form of technology companies and those in the consumer discretionary and internet retailing sectors.

This composition distinguishes the U.S. market from those in Europe and Japan that are more influenced by companies growing at a slower pace in sectors such as financials, materials, and industrials.

But the persistent trend of higher valuations for the S&P 500 has sparked frequent warnings from investors that future returns for U.S. blue-chips will eventually prove disappointing.

One popular snapshot of S&P 500 valuation is the Shiller cyclically-adjusted ratio of price to average earnings over 10 years. The ratio’s current level of 36.9 has only been bettered by the late 1999 peak of 44 during the internet-inspired dot-com boom in equities at the turn of the century. Stock market returns from the following decade were poor, courtesy of two very nasty bear markets.

In light of that experience, it is understandable why there is anxiety that a similar period of subpar returns may befall Wall Street. Investors have crowded the exit in recent weeks from technology companies yet to prove their profit-making bona fides as well as soured on the previously booming area of special purpose acquisition companies, which float on the stock market and then go hunting for a company to buy.

The current sense of angst is compounded by the uncertainty over the true trajectory of inflation, and the future rate of change in bond market interest rates from their current low levels.

Then, there are questions about the further expansion of technological innovation and to what extent current and forthcoming fiscal stimulus drives stronger underlying growth in the economy and corporate earnings.

Although valuations are a good starting point for assessing the scale of future returns, they are just one element of a broad financial picture.

One factor investors need to consider is the production line of new companies joining the index in the coming decade, a development reflecting the vibrancy of U.S. venture capital nurturing start-ups in new lines of business that in due course become bona fide blue-chips.

“I don’t worry about current valuations because they are based on today’s S&P 500 and the changes in the composition of the index will drive future returns,” says Nicholas Colas, co-founder of DataTrek Research LLC in New York.

For example, a decade ago, energy accounted for 12 per cent of the S&P 500, and in light of the sector’s subsequent poor performance, it should have hurt long-term returns for investors tracking the benchmark. Instead, the rise of technology companies transformed the S&P 500 and supercharged its performance for much of the past 10 years.

By the start of 2021, that shift drove S&P 500 share prices to a lofty level of trading at 22.6 times their forecast earnings during the next 12 months. The current 12-month forward price-to-earnings ratio has dropped back to 21 in the wake of improving earnings. However, this ratio does remain above the 17.9 average of the past five years, and a reading of 16 over the past decade, according to FactSet Research Systems Inc.

The modest decline in valuations this year is likely to have more room to run given what is typical of an economic recovery. Equity prices in the wake of a recession rise sharply on expectations of higher future earnings and then the valuation multiple eases once companies affirm that is happening.

Companies with earnings that benefit from an improving economy have been rewarded at the relative expense of tech names that did very well for much of the past year. Expensively valued stocks will have to demonstrate that their earnings prowess vindicates high expectations.

Given the importance of technology, it will probably limit the S&P 500′s overall performance. So far this year, U.S. blue-chips have lagged Europe, where more companies are classic economy types.

Some will see this as reinforcing a shift in portfolios away from the S&P 500, while others fret it is a sign that a bigger reckoning awaits Wall Street.

Another view is that for all the likely bouts of anxiety from shifting interest rates, data surprises and policy decisions, the tech-heavy S&P 500 remains in a long-term uptrend that began in 2013. Downgrading U.S. blue-chips may still prove costly in the future, in spite of voracious valuation warnings from bears.

“The S&P keeps surprising to the upside by generating stronger profits growth and, so far, the optimists have triumphed,” Mr. Bianco says.

© The Financial Times Limited 2021. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied, or modified in any way.