Are U.S. stocks worth the price?

The resilient U.S. economy has led to an improved earnings outlook for U.S. stocks, but many investors worry that valuations—represented by the forward price-to-earnings (P/E) ratio—are too expensive given the uncertainty surrounding interest rates and the economy.

U.S. stock valuations seem elevated relative to historical averages and to stocks in other regions of the world (Figure 1). But a deeper analysis of the S&P 500 Index reveals that a handful of mega-cap stocks that account for a large share of the index are responsible for the high valuations. This group of stocks—which includes Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla—has become widely known as the Magnificent 7.

Collectively, the Magnificent 7 hold a P/E ratio that is considerably higher on a market cap-weighted basis than the S&P 500 Index. Without these seven stocks, the P/E ratio of the index is relatively modest (Figure 2). In other words, the broader U.S. stock market does not look expensive through this lens; however, valuations for the Magnificent 7 look expensive.

Whether these elevated valuations are warranted is a difficult question to answer, but one simple way to provide a sanity check is to compare the P/E ratio of an index to its return on equity—a measure of how profitable and efficient a company has been over the past year. For the Magnificent 7, their high valuations were accompanied by similarly high market cap‑weighted returns on equity as of October 23. Whether these seven companies can sustain the level of profitability and efficiency that they have thus far exhibited remains to be seen.

When taken in context, the elevated valuations of U.S. stocks in general and the Magnificent 7 collectively do not appear unreasonable. As a result, our Asset Allocation Committee currently holds a broadly neutral allocation to U.S. equities despite elevated valuations amid an uncertain environment.

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of November 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

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