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Island Investing

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Perspective on Valuations of the Magnificent 7

From an email sent to IIM investors on March 17, 2024…

The stock market continues to reach new heights, driven by a stronger-than-expected economy and the largest technology stocks. In particular, Nvidia, a maker of graphics chips used in artificial intelligence applications, recently helped push markets higher after beating Wall Street earnings expectations. This added to gains from the group known as the “Magnificent Seven,” which consists of fast-growing technology companies – most of which have market capitalizations of a trillion dollars or more. Some investors are nervous that the market has risen so far, so fast, while others have a growing fear that they are missing out. What’s the best way for long-term investors to think about a market that has climbed so quickly?

Large technology stocks have propelled the market

Perhaps the most important consequence of the bull market rally of the past year is that valuation levels are no longer as attractive. The S&P 500 has gained about 28% during this time while the Nasdaq and Dow Jones Industrial Average have risen 40% and 19%, respectively. As a result, the price-to-earnings (P/E) ratio for the S&P 500 is now 20.4, meaning that investors are willing to pay $20.40 for every dollar of expected earnings. While this is below both its peak before the 2022 bear market as well as the historic high during the dot-com bubble, it is still well above its long-run average of 15.6. Not surprisingly, the P/E ratio of the Information Technology sector of the S&P 500 is one of the loftiest at 28.1.

Why are valuations important to long-term investors? Simply put, valuations are among the best tools that investors have to gauge the attractiveness of the stock market over years and decades. Unlike stock prices on their own, valuations don’t just tell you how much something costs, but what you get for your money. Holding shares of a company means you are entitled to a portion of its value, which ideally grows over time. Valuations are correlated with long-term portfolio returns for that reason – and buying when the market is cheap can improve the chances of success, while buying overvalued stocks when the market is already relatively expensive can be a drag on future returns.

That said, valuations are neither market-timing tools, nor do they explain all market movements. Instead, they are guideposts that can help investors determine appropriate strategies based on their financial goals. As the below chart shows, most valuation measures are now well above their long run averages, including price-to-earnings, price-to-cash-flow, and dividend yield. This is partly because the underlying fundamentals are still catching up with the market rally. As sales grow, earnings improve, and interest rates stabilize, valuations could begin to improve as well. So higher valuations are not a reason to avoid stocks altogether – but they are a reminder to choose your stocks thoughtfully, and for more balanced investors, to focus on diversifying across sectors and asset classes.

Valuations have increased over the past year

Case in point: the rally in mega cap technology stocks is an important reason to be diversified across a variety of sectors – including the less favored but more undervalued ones. Investors with long time horizons ought to remain balanced across a variety of sectors and styles tied to trends in the underlying economy.

Beyond today’s valuations and returns, another concern that some investors have is that a small group of companies is having an outsized impact on the overall stock market. Perhaps the simplest way to see this is to compare the standard S&P 500 index, which places a weight on each stock based on its size, to one which gives an equal weight to each stock. Both weighting methods are useful in different ways: using market cap weights provides a more accurate sense of the composition of the stock market – i.e. where the dollars are invested. Using an equal weighted index, however, helps investors benefit from a less concentrated allocation of the same companies – which is why we have been making that exact substitution across many of the diversified accounts we manage here.

Historically, stocks of all sizes have contributed to market returns

As the above chart shows, large companies have not always dominated stock market returns. For much of history, the largest companies were often seen as the most boring (“blue chips”) and primarily served as a source of stable dividends. Over the past 15 years, the equal weight S&P 500 index has actually outperformed the market cap-weighted index. Although the largest companies have outperformed in recent years, a longer perspective paints a different picture. And it’s important for investors to keep this in mind while making portfolio decisions.

The bottom line?

With the market driven to all-time highs by a small group of large tech stocks, investors should be mindful of valuations. History shows that doing so can be helpful in achieving long-term financial goals regardless of market conditions.

Please let us know if you have any questions.

– Cale