Advertisements
Recent

FAANG SCHMAANG: Don’t Blame Over-valuation Solely on Information Technology

GMO – FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology, October 2017

Do the old rules apply to a “new” S&P 500?

  • As we entered the roaring 1980s, the S&P 500 was dominated by lower-price-multiple, cyclical companies. Energy, Materials, and Industrials sectors accounted for 45% of the S&P 500 while IT and Health Care made up 15% of the index
    • IT and Health Care’s weight has expanded to 38% today, while the lower-multiple cohort has declined to under 20%
  • Today, at 27.3x, the P/E of the S&P 500 is quite elevated, trading 46% above its long-term median dating back to 1970
  • Comparing today’s P/E of the market to its long-term median valuation level makes the assumption that the level the S&P 500 traded at on average in the past is “fair” today
  • If index composition along some risk dimension one cares about, such as country or sector weights, changed over time, history might not be a very relevant anchor
  • As the S&P rotated in and out of lower- and higher-multiple sectors, the fair value line has shifted between 17.6x and 20.6x P/E
    • On a dynamic sector basis, S&P 500 is still a lofty 39% overvalued
  • If the sector shift to IT accounts for only some of today’s expensiveness, what gives? Pretty much every other sector, save Energy, is trading expensively relative to its median valuation since 1970
  • Financials, Utilities, and Consumer Discretionary sectors are particularly expensive relative to their own history, trading at premiums of 95%, 80%, and 58%, respectively
  • Interestingly, the 3 sectors that don’t look particularly expensive, Consumer Staples, Health Care, and IT, have historically been Growth sectors
    • Growth prospects for Consumer Staples and Health Care today are far from obvious and might not justify valuations normal by historical standards

P/E multiples tell only part of the story

  • While P/E multiples make it clear that S&P is trading expensively relative to long-term medians, it is true that on a Z-score basis, current levels are not too extreme
    • Few sectors are trading above 1 standard deviation expensive
  • When viewed through a sales lens, today’s valuations look even more disturbing
    • S&P 500’s current P/S ratio of 2.1 is 117% overvalued relative to its long-term median and trading just under the peak valuation it reached in March 2000
    • Though the dynamic sector approach applied to P/S suggests the S&P 500 warrants a modestly higher P/S multiples, the S&P 500 would still be 103% overvalued by this measure
    • In fairness, many of today’s larger cap IT companies should trade at higher than historical P/S multiples given their cost structures are significantly more attractive than “old school” tech companies and the broader market
    • When we look at Price/Gross Profits, S&P 500 looks “only” 64% overvalued adjusting for sector composition (75% without sector composition adjustment)

Does EAFE deserve to trade at a lower multiple given its lower weight in IT?

  • Developed ex-US markets as measured by the MSCI EAFE index do look quite different than the US based on sector weights
  • At the end of September 2017, 27% of MSCI EAFE index was in Energy, Materials, and Industrial companies while S&P had only 19% exposure
  • On the other hand, IT and Health Care make up a measly 17% of the MSCI EAFE while they account for a whopping 38% of the S&P 500
  • Today, there is a wide gap between the P/E multiple for S&P 500 and MSCI EAFE: 27.3x vs 20.7x
  • Even after neutralizing the S&P 500 index for sector differences, the index is trading at a significant 26% premium to the MSCI EAFE index

Conclusion

  • Significant sector differences exist across markets and within the same market over time
  • As economies and markets continue to evolve, so too will shifts in sector composition
  • Importantly, broad equity markets that bear similar levels of risk should deliver similar levels of returns and thus be priced in line with each other
  • Today’s higher S&P 500 weight in the relatively expensive IT sector is cause for some of its expensiveness but it does not explain away the bulk of its high absolute and relative valuation level
  • No matter how you cut it, S&P 500 is expensive

Image Source: GMO

Advertisements