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Equity market valuations: a deeper look

May 1, 2017 | Commentary

  • Market commentators have for some time looked at the P/E ratio of broad U.S. large cap stock indexes like the S&P 500 and suggested that today’s near-record levels represent a severely overvalued market and a risk of a major correction.
  • Market averages by definition consist of potentially divergent sectors. Most of the times the differences are small and evolve gradually. The shock to the energy sector that began in 2015 was neither small nor gradual and it may have warped our impressions of the market as a whole.
  • Excluding the 7% energy sector recently from the S&P 500 Index creates a less dramatic picture of the general market. Stock market valuations have risen in the last few years, but the average stock is likely not as expensive as the total index would make it appear.
  • Index distortions can also come from specific stocks. If Amazon, which has a trailing twelve months P/E ratio of 183 and a weight in the S&P 500 of 1.6%, had an “average” valuation, the P/E ratio of the entire index would be another .3 points lower. The lesson is that these numbers can move around a lot and nobody should obsess over where the recorded index is today versus historical values that may have very little comparability.

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