Higher equity valuations: A historical perspective

Summary

By most measures, large cap valuations are rich relative to history. Yet, the stock market's sector composition and profit margin profile has changed significantly over time. This makes for a challenging apples-to-apples comparison. 

We agree that valuations likely suggest that longer-term returns will be somewhat lower than the historical norm, given today’s higher starting point, yet we don’t find current valuations overall as exuberant. We still see upside left in the bull market, albeit at a more modest pace.

• U.S. large caps are trading well above their historical averages. Outside of large caps, however, market valuations are more reasonable.

• Notably, S&P 500 valuations have trended higher over recent decades alongside higher profit margins.

• The S&P 500’s sector composition has shifted toward higher growth, higher valuation sectors; the S&P 500 technology sector weight alone now accounts for 30% of the index versus 6% in 1990.   

• Another reason why valuations are likely somewhat higher more recently is due to increased investor confidence in Corporate America. Despite a once-in-a-generation pandemic and an inflation shock, S&P 500 forward earnings estimates are 44% above where they were at the end of January 2020. 

• Structurally, low-cost access to the market in the form of lower trading commissions and less price-sensitive buyers given the significant growth in 401k funds and index funds also suggest a somewhat higher premium level relative to history.  

• We estimate that passive vehicles, including mutual funds and exchange-traded funds (ETFs), now account for 60% of the total U.S. equity fund assets, up from 4% in 1993.