asset allocation | november 16, 2023
Are U.S. Stocks Worth the Price?
The Magnificent 7 have distorted U.S. equity valuations.
5:07
Thus far in 2023, the U.S. economy has proven quite resilient despite the headwind from higher rates. Although this resilience has led to a steady improvement in the earnings outlook for U.S. stocks as the year has progressed, many investors remain concerned because they believe stock valuations—typically represented by the forward price-to-earnings ratio—are too expensive.
In fact, when one compares the current P/E of the S&P 500 to its historical averages, it does appear elevated. As of October 23rd the forward price-to-earnings ratio of the S&P 500 stood at 17.5x, which is somewhat higher than the 25-year average of 16.4x. While the difference is not substantial, many investors believe that an elevated P/E is very much unwarranted given the numerous headwinds the equity market currently faces.
U.S. stocks also look expensive when compared to other regions of the world. For instance, the forward P/Es for the MSCI Europe, Japan, and Emerging Markets indices are all significantly lower than that of the S&P 500.
A closer look at valuations reveals that the elevated valuations of U.S. stocks is mostly attributable to a handful of stocks that account for a very large share of the S&P 500 Index. This group of stocks has become known as the “Magnificent 7,” and it includes Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. As of October 23rd, these seven stocks accounted for over 28% of the S&P 500 Index.
And this group of stocks holds a P/E ratio that is considerably higher than the rest of the index. On a market cap-weighted basis, the Magnificent 7’s forward P/E was 27.4x as of October 23rd. Consequently, if we were to remove these seven stocks from the index, the S&P 500 P/E would be a relatively modest 15.4x. So we can conclude that U.S. stocks are not broadly expensive; rather, the Magnificent 7 are.
Since we know that U.S. stocks appear to be expensive primarily because of the Magnificent 7, the pertinent question becomes: Do these stocks deserve to be this expensive? This can be a very difficult question to answer—one that typically requires deep fundamental analysis. But one simple way to provide a sanity check is to compare the P/E of an index to its return on equity—a measure of how profitable and efficient a company has been over the past year.
When we make this comparison, we can see that the very high valuations that these companies hold are accompanied by a similarly high ROE. As of October 23rd, the Magnificent 7’s ROE on a market cap-weighted basis was 32.6%, while the rest of the S&P 500 Index was 17.2%. And further comparisons to other regional equity indices show a similar relationship, with the MSCI Europe, Japan, and Emerging Markets indices all holding dramatically lower ROEs to go along with their lower valuations.
The bottom line is that the elevated valuations of the Magnificent 7 collectively and U.S. stocks in general are not unreasonable when taken in context. The real question is whether or not the level of profitability and efficiency that these seven companies have exhibited can be sustained.
In conclusion, while U.S. stocks may seem overvalued on the surface, a deeper analysis shows that this is driven only by a handful of companies whose valuation collectively may not be 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.
Key Insights
At first glance, the S&P 500 Index’s elevated valuation could be concerning given the numerous headwinds facing equity markets.
A deeper analysis reveals that a handful of mega-cap stocks in the S&P 500 Index have distorted U.S. equity valuations, but their prices overall may not be unreasonable.
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.
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U.S. stocks look expensive
(Fig. 1) P/E ratio of U.S. stocks relative to history and compared to other regions
As of October 23, 2023
Actual outcomes may differ materially from forward estimates.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. MSCI Indexes. See Additional Disclosures.
U.S. stocks are represented by the S&P 500 Index.
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.
Magnificent 7 have distorted U.S. equity stock valuations
(Fig. 2) Comparing valuations of mega-cap stocks versus other S&P 500 stocks
January 1, 2008, through October 23, 2023.
Actual outcomes may differ materially from forward estimates.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. S&P 500 Index. See Additional Disclosures.
P/E ratios are market-cap weighted.
*The “Magnificent 7” stocks are Apple, Alphabet, Amazon.com, Meta Platforms, Microsoft, NVIDIA, and Tesla. The specific securities identified and described are for informational purposes only and do not represent recommendations. Not representative of an actual investment. There is no assurance that an investment in any security was or will be profitable.
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.
Additional Disclosures
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.
The S&P 500 Index is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”) and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); T. Rowe Price’s Products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index
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.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual outcomes may differ materially from any estimates or forward-looking statements provided.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences. All charts and tables are shown for illustrative purposes only.
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