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THE S&P 500 INDEX just hit a new all-time high, topping 5,000 for the first time. Is it now too high? For investors concerned about market risk, this is an important question. But it isn’t an easy one to answer.
For starters, there’s no single definition of “too high.” Consider the price-to-earnings (P/E) ratio, the most common measure of market valuation. By this metric, the market does indeed look pricey. The P/E of the S&P 500 stands just a hair below 20 based on expected 12-month earnings—far above its 40-year average of 15.6. Should that concern us?
The reality: The economy today isn’t the same as it was 30 or 40 years ago, and that has implications for valuation ratios. Specifically, the companies that now dominate the market have very different financial profiles.
The five largest S&P 500 companies today are Apple, Microsoft, Amazon, Nvidia and Alphabet (parent of Google). Together, these five companies account for more than 20% of the S&P 500’s total value. From a financial perspective, what makes them notable is that, over the past 10 years, their profits have grown at an average 25% per year—a remarkable pace for companies of their size.
We can contrast these companies with the market leaders of the past. In 2001, the five largest companies in the S&P were General Electric, Microsoft, Pfizer, Citigroup and Wal-Mart. Aside from Microsoft, the market leaders consisted of an industrial company, a pharmaceutical manufacturer, a bank and a retailer. While they were all large companies, the profitability of these kinds of businesses doesn’t compare to that of the tech companies now driving the market. That’s why many argue that today’s higher valuations are justified.
Another reason to see today’s market as fairly valued: Traditional valuation ratios paint a distorted picture. According to an analysis by JP Morgan, as of Jan. 1, the average P/E of the 10 largest companies in the S&P was a lofty 27. By contrast, the average valuation of the other 490 companies was just 17—not far above the index’s long-term average. Through this lens, the market today isn’t more expensive than it’s been in the past. It’s just that the unusual group of companies that sit atop the market are much larger, more profitable and faster-growing than the rest, and that makes the market appear more expensive than it really is.
To be sure, some investors remain unconvinced. They argue that international markets offer far better value. Indeed, at year-end 2023, the U.S. stock market was among the world’s most expensive. That’s true—mathematically—but boosters of U.S. stocks are quick to point out why that’s the case: Nowhere else in the world is there a group of companies that matches the tech leaders in the U.S.
Yes, there’s Alibaba in China, Samsung in Korea, TSMC in Taiwan and others. But no international market has the sort of concentration of fast-growing technology companies that the U.S. has. That’s another reason the market here may not be as expensive as it seems.
So far, we’ve only looked at the market through the lens of the P/E ratio, but it isn’t the only yardstick. Yale University economist Robert Shiller is co-creator of an alternate barometer known as the Shiller P/E. During the 2021 rally, he made this statement: “The stock market is already quite expensive. But it is also true that stock prices are fairly reasonable right now.” Shiller explained the seeming inconsistency by arguing that there is more than one way to assess the market. Through one lens, it might appear expensive. But through another, it might appear reasonably priced.
For the past several years, in fact, Shiller has advocated a successor to his original P/E. He calls the new one the excess CAPE ratio. This new metric looks at stocks relative to bonds, rather than comparing stocks to their own historical average. The upshot: It’s another example of how market valuation is in the eye of the beholder.
Without the benefit of hindsight, of course, we can’t know whether the market today is actually too high. How can investors manage that uncertainty? I have three suggestions:
Ignore the market. Since we can’t be sure where it’s headed, investors’ best bet may be to simply ignore where the market stands at any given time. In a recent article, researcher Nick Maggiulli asked this question: Historically, if investors had put money into the market on days when it was at all-time highs, how would those investments have done relative to investments made on all other days? His conclusion: It depends.
Over one-year periods, investing at all-time highs yielded better results than investing on all other days, because the market exhibits momentum. But over five- and 10-year periods, returns were lower for investors who put money to work at all-time highs. That makes intuitive sense, but there’s an important caveat: Returns were still positive in all cases.
In other words, we’d all prefer to invest when the market’s cheap, but investors were still better off putting money into the market at all-time highs than not at all. The lesson: Investors who wait on the sidelines in the hope of earning better returns may miss out on receiving any returns.
Ignore commentators. I often recommend tuning out the advice of market experts. That’s because the investment world is full of commentators who became famous with one—but only one—successful prediction. These include Michael Burry, made famous by The Big Short, who in recent years has predicted a series of crashes that haven’t materialized.
Robert Shiller, who himself has an above-average track record as a forecaster, acknowledges how difficult it is. Referring to his own P/E measure, he wrote in 2014 that, “The ratio has been a very imprecise timing indicator.” The implication: Market measures are interesting, but we shouldn’t see them as anything more than that.
Diversify. While I’m not worried about the U.S. stock market, no one should ever be too confident. To appreciate that, look no further than Japan’s Nikkei 225 index. In December 1989, it closed at 38,957. Where is it today? At 36,897—still below where it stood more than 34 years ago. The performance has been horrendous.
While Japan has faced some unique challenges, including deflation and stagnant population growth, we can’t ignore this example. Fortunately, there’s a simple solution: diversifying your portfolio internationally. That way, if a problem does materialize in the U.S., you’ll have time to wait it out. Some investors recommend holding as much as 50% of your stock portfolio outside the U.S. I prefer something closer to 20%. But the important thing is to simply have some exposure.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X (Twitter) @AdamMGrossman and check out his earlier articles.
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One of my uncles was obsessed with the net worth of the companies he invested in. That’s an accounting construction, and I’m not sure how valid it was even then. With the high-tech companies, the net worth is mostly intangible and, at best, a guess.
Adam, you seem to always have your finger on the pulse of the market.
The best time to plant a tree is 20 years ago. The second best time is now. Analogous for buying low cost diversified index funds.
Excellent analysis of market today. Learning from history has limitations. Current situation, as you explain, is somewhat unique. Market is forward looking, Fed is on hold and may cut rates in 3rd quarter. There is $6T sitting in money market funds. A portion of it is expected to move back to stock market. If and when that happens, FOMO will kick in, driving the market higher. Market can be irrationally exuberant for a long time. On the flip side, there are many head winds that can drive the market lower: Geopolitics, commercial real estate, lower earnings etc. Best, as you said, is to stay the course.
Thanks for the article Adam. Like many, I first get your weekly article in your weekly newsletter and then reread it on Sunday on Humble Dollar. Reading it twice often results in my thinking more about the content you provide.
I am getting some international exposure by owning VTWAX as part of my portfolio. VTWAX currently has an approximately 39% international equity per Morningstar.
Your article notes some of the largest foreign companies consist of Alibaba in China, Samsung in Korea, and TSMC in Taiwan. I find TSMC as the 14th largest holding in VTWAX on Morningstar, but do not find listings for Alibaba (Alibaba Group Holding Ltd. ADR on NYSE) or Samsung (Samsung shares don’t trade on a U.S. stock exchange and the company doesn’t offer American Depository Receipts) listed in the 25 largest company rankings.
Any thoughts on what Vanguard knows that I do not understand as to why some of the largest international stocks in a world market capitalization index like VTWAX are omitted from the index?
Followup-
I have now found BABA in the VTWAX Vanguard/Prospectus/Annual Report but it’s value in VTWAX at last fiscal year end was $96,702,000 so it is in the fund but not close to being in the top 24 holdings. Why is still unclear to me. Could Vanguard be considering the market capitalization just the equity not owned by the government of China?
Additional info
I found the answer on the bogleheads.org wiki –
To make their indexes more easily investable for index funds, index providers have adopted free-float weighting, and added buffer zones to their methodologies. Free float weighting eliminates non-trading shares in a company’s capital base. These can include cross-ownership of shares by other companies, government owned shares, privately held shares, and other restricted shares. A company’s free-float weighting will reflect the actual amount of shares available for public investment.
There is one problem with pricing the megacap tech stocks. Yes, their sales and profits have grown for the past 10 years at an astounding rate. But their current prices are based on future grow in the next ten years.
Amazon had about $575 billion in revenue in 2023. Do you think they can grow their revenue to $5.75 trillion by 2033? Microsoft had revenue of $204 billion – do you think they can grow to $2 trillion? These are the numbers their prices imply. Maybe this will happen, but when you buy these stocks, the prices are already set as if this growth were guaranteed. What if it doesn’t happen? Then the price will go down. What if this does happen? Well, the price should stay the same as it is now, because the companies will be so large they’ll have 100% of the market in their industry, and there’s no further room to grow.
– “Microsoft had revenue of $204 billion – do you think they can grow to $2 trillion? These are the numbers their prices imply.”
MSFT price is $420. According to Google “get lucky” search it is projected to be $1200 in 2033. Why do you think it would need 2 trillion revenue to reach that? Valuation isn’t a function of growth. Historically growth is a very poor indicator of valuation. Valuation in the LT is a function of terminal cash delivery, which is returns * duration.
I wish you had some replies here to this point. (I am of no use)
It seems like people are caught up in the percent return they’re going to get, or having a “smooth ride,” and not focusing on having the most money at whatever future point they need it (e.g., retirement). Most people invest every paycheck, so the money is there every two weeks, or twice a month or whatever cadence, regardless of what the stock market is doing. If you think you’re going to “time the market,” your competition is fund managers with a research staff behind them.
If you just invest in whatever your target asset allocation is each paycheck, and the stock market goes up–hooray, your portfolio goes up. If the market goes down, future investments will be made at a lower price, increasing your return when the market finally does go up.
There is certainly a case for not being 100% in the S&P500 or US Total Market depending on one’s age and temperament. But, trying to time the market requires one to be correct at least *twice*–once to know when to get out, and again to know when to get back in.
“Most people invest every paycheck”??
The 60% of Americans who report living paycheck-to-paycheck would strongly contest that sweeping generality.
I think the 60% number is highly dubious. Doomer porn.
As author advisor Nick Murray says: Nobody really knows anything about market direction but the best time to add to a high quality diversified equity portfolio may just be whenever you have the money. The best time to sell may be whenever you need the money. This may be all you need to know
PS-his book is a must read. Simple Wealth
I agree with Tobin and Murray. But I heard it first in the parable of the talents, which has apparently been around at least a couple thousand years. If you want to read that take, you can find it by googling “parable of the talents.”