It's fair to say that the U.S. stock market has had a great run in recent years. In 2013, the S&P 500 index was at 1,480 and trading at 16x the earnings that the companies in the index generated (a P/E ratio of 16). So that was 2013, now let's fast forward to the present, rather than trading at 1,480 the S&P 500 is now at 2,560 representing 25x earnings. So the S&P 500 today is 73% higher than it was a little under 5 years ago, delivering an annual return of approximately 12% a year, that's not bad by historical standards. One reason for this move is because we haven't seen a US recession recently. Recessions are generally negative for stocks, as companies typically sell fewer products and make less profits.
Earnings Have Not Kept Pace
But the market's up 73% and yet the P/E has only risen 60% so what accounts for the gap? It's rising earnings. Earnings for the S&P 500 today are actually up around 10% since the start of 2013. Nonetheless, even with modest further growth in earning this year, earnings are fairly close to where they were 5 years ago. But valuations aren't. The recent rally in the S&P 500 is more about investors being willing to pay up for companies, than those companies making greater profits. It's unusual for the long-term to see the market move so much on valuation rather than based on earnings, over the long-term the market tends to follow earnings growth more closely. Unfortunately for long-term investors the average P/E ratio for the S&P 500 is around 15x, so much lower than today's figure suggesting US stocks could decline if valuations were to return to the average levels of history.
A Changing Mix: Oil Declining, Tech Rising
One thing that has changed though, is the mix of companies in the S&P 500. Weightings are changing all the time, the way the S&P 500 is constructed, if the price of Apple rises, it assumes a larger share of the index. Conversely, if the price of Exxon Mobil falls, it becomes a smaller piece of the S&P 500. And that's basically what we've seen. Since 2013 tech companies have risen strongly and become a much larger piece of the index. Tech firms used to be less than a fifth of the S&P 500 and now they are closer to a quarter of it. This is because earnings for the sector have grown strongly, up almost 40% since 2013. Most other parts of the index have struggled to grow that fast. Healthcare companies have also successfully grown earnings, and have also increased their share of the S&P 500 index, but aren't as significant as tech firms. Even though the overall earnings of the S&P 500 haven't moved that much, earnings from tech and healthcare are up sharply.
So if tech and healthcare firms are growing so strongly, how come the index hasn't seen rapid earnings growth as a whole? Well, though the story for the markets and the economy overall has been positive it's actually been a pretty gloomy time for energy companies and financial firms (such as banks) in recent years. Even a very well managed energy company has trouble growing profits when the price of its main product declines, and that's what has happened to oil over the past 3 years. The oil price has roughly halved from $100 a barrel in 2013 to closer to $50 today and unsurprisingly, oil company profits have basically fallen off a cliff. The impact on the energy sector has been pretty dramatic and it's share of the S&P 500 index has almost halved. Financial companies have also had headwinds, low interest rates, costs from the last recession and regulatory changes have meant that financial companies have seen basically flat profits, and again financials are now a smaller portion of the S&P 500 than they were a few years ago.
So the story of the S&P 500's recent sharp rise, is not all companies moving in lockstep and not really about growing profits. Yes, investors have been willing to pay more for the earnings that S&P 500 companies generate. And yes, certain companies, such as tech and healthcare firms have seen strong profit growth. But, importantly this has been offset by mediocre performances by energy companies and financial firms, which used to be a quarter of the index and have declined to a fifth of it.
Tech And Pharma Valuations Are Lofty
This matters because the market has been unwilling to give high valuations to the earnings of financials and energy firms, especially when their earnings are flat and declining, but the market is very willing to give high valuation to certain tech or pharmaceutical firms. As valuation expert Aswath Damodaran's data suggests the market appears happy to pay 60x earnings for tech firms and pharma companies, yet closer to 15x for oil companies and 20x for banks. This big difference is, in part, because some tech and pharma firms are loss-making, boosting the P/E of the sector (if your earnings are 0, your P/E ratio will be infinite). Even a small shift as we've seen of around 7% in the S&P 500 from apparently conservatively valued stocks, like oil companies and financials into pharma and tech can push up the valuation of the index a lot, because the difference in valuation of the different sectors is large. That is one reason for why the US stock market looks expensive currently. It has a greater weight to pharma and tech trading and lofty valuations and a smaller representation of banks and oil firms than it did just 4 or 5 years ago.
So, the reason the S&P 500 has moved up in recent years is not due to economic growth, but mostly because investors are willing to pay more for a dollar of earnings than they were 5 years ago. In part that's because more of the earnings of the S&P 500 now has a larger weight to apparently high growth tech and pharma firms and investors are willing to pay a premium for them. However, surprisingly for a market that's risen over 70%, earnings are up just 10% over the same period. It's not a market for the feint-hearted and bonds and international diversification may be worth considering rather than just pilling into U.S. stocks.
