Valuations are slipping even as stocks hover near records
Strong corporate earnings are making stocks look less expensive than they did before
Stock-market valuations are lower now than they have been for a while, but that doesn’t mean shares are cheap.
Despite another robust corporate earnings season, the S&P 500 has inched up just 1.5% over the past three weeks as simmering trade tensions and signs of slowing growth at big technology companies sapped investor confidence. Those issues have helped drive valuations down to their lowest levels of the year, even with the broad stock-market index hovering just 0.5% shy of its January high.
The S&P 500 trades at 18.8 times earnings over the past 12 months, a basement valuation that is lower than February’s trough of 21 times earnings, according to FactSet. At the S&P 500’s peak in January, the index traded at nearly 22 times earnings, well above its current level.
Strong corporate earnings are making stocks look less pricey than they did before. Companies in the S&P 500 have posted double-digit profit growth for the past three quarters to help earnings catch up with the S&P 500’s 7% advance this year. For the latest quarter, profits are on track to rise 24% from a year earlier, the best pace of earnings beats since 2008, according to FactSet.
But by other measures, stocks still look expensive—the S&P 500 is currently trading in the 88th percentile of historical valuation, Goldman Sachs said in a recent report, while the median stock is at the 97th percentile.
Individual stock prices are steep, in part, because of the surge in shares of technology companies. The popular corner of the market, which has been a big contributor to the run-up in major indexes over the past several years, continues to command big-ticket multiples that worry some investors.
“Valuations have gotten more extreme in the last three to five years,” said Mike Balkin, a portfolio manager at William Blair. “The FANG stocks have looked especially expensive, but if you didn’t own them, your performance suffered,” he said, referring to the crowded trade of Facebook Inc., Amazon.com Inc., Netflix Inc. and Google parent Alphabet Inc.
Tech companies in the S&P 500 are trading at nearly 21 times their earnings over the past 12 months, well above the broader index and most other sectors. That’s partly because investors have sought safety among shares of technology companies at any sign of trouble in the market this year, opting for a stable of highflying growth stocks that have outperformed most other popular investing strategies throughout the nine-year rally in U.S. stocks.
Wall Street’s infatuation with technology stocks briefly stalled last month after Facebook and Netflix reported financial results that fell short of investors’ expectations. Those stocks have stumbled 8.9% and 15%, respectively, over the past month. That helped shave nearly 2% from S&P 500 tech companies’ trailing 12 month price-to-earnings ratio, according to FactSet.
Investors are questioning whether those companies and others in the tech sector can continue their heady growth paths unabated. New regulations in Europe and the prospect for tougher oversight in the U.S. have showed some signs denting profits. Facebook, for example, said its European user base took a hit after a tough new European privacy law went into effect in the second quarter.
“Investors are now asking how long can growth stocks really continue to outperform,” said Matt Forester, chief investment officer at BNY Mellon’s Lockwood Advisors. “It’s reasonable to question whether some of those expectations had been too high in the space.”
Money managers are using the weakness among tech companies to urge clients to trim tech-heavy portfolios and put that money into the market’s cheaper pockets. Wells Fargo Investment Institute, for instance, cut its view of tech stocks to “neutral” for the second half of the year and has a more favorable view on financial stocks. Inflows into tech-focused funds have slowed from earlier this year, and popular vehicles, like the Technology Select Sector SPDR fund, have been suffering redemptions some weeks. Investor outflows totaled nearly $300 million for the tech fund in the past week, according to FactSet.
Some investors have been plowing that money into other asset classes, such as short-term government bonds, whose yields have jumped to their widest margin against the S&P 500’s dividend yield in years. Others have been opting for more defensive footing among equities, putting money into shares of financial firms, health-care companies and utilities, where valuations are more attractive.
Health-care stocks and utility firms in the S&P 500 are each trading about 17 times their earnings over the past year, while financial stocks offer an even bigger bargain at 15 times earnings, according to FactSet.
The shifting landscape has led to a rare break in leadership for tech stocks. The health-care, financial and industrial sectors of the S&P 500, corners of the market that had been long out of favor, are outpacing the tech sector’s 5% gain so far this quarter.
Facebook’s earnings spooked investors enough to “begin shifting assets to the more value-oriented areas” of the market, said Robert Pavlik, a senior portfolio manager at Slate Stone Wealth, in a recent note to investors. “We believe this is just the beginning foray into these groups.”