There are real concerns that the stock market is in a bubble, or something close. And those concerns aren’t limited just to high-flying tech stocks. Major indices like the S&P 500 too could be at risk.
To be sure, it’s far from guaranteed that the entire market has run too far. There are reasons for optimism toward U.S. equities.
Even the rally from March lows, amid the novel coronavirus pandemic, makes some sense when taking the long-term view. The changes wrought by the pandemic may well be, overall, positive for U.S. corporations.
Meanwhile, bubble concerns have been around for years now. Yet major indices, including the S&P 500, have continued to climb.
Reasonable investors can draw different conclusions as to whether the gains are justified — or will continue. But those who are concerned about the market as a whole should at least realize that the S&P 500 isn’t necessarily a safe place to hide out.
The S&P 500 Valuation Question
We’ve seen a number of stocks in sectors like electric vehicles or crypto plays triple or better over the past three-plus months. The NASDAQ Composite, generally a more tech-heavy index than the S&P 500, returned nearly 44% in 2020.
But the S&P 500 has valuation concerns of its own. It rallied 16% in 2020 on top of a 29% gain the year before. And that’s with significant exposure to industries that took a big pandemic hit.
For instance, as of Dec. 31, energy still accounted for 2.3% of index weighting. The figure was 6% at the end of 2019. Health care and financials, both of which have struggled to varying degrees since March, totaled 24% of the index at the end of 2020.
Meanwhile, relative to earnings, valuation is at a multi-year high. The Shiller PE Ratio, a cyclically-adjusted measure of the index’s price-to-earnings multiple, has reached levels rarely seen before:
To be fair, those struggling sectors to some extent inflate the index’s broader multiple. On a forward P/E basis, the two most expensive stocks in the S&P 500 are refiner HollyFrontier (NYSE:HFC) and travel platform Expedia (NASDAQ:EXPE).
Of course, #3 is Tesla (NASDAQ:TSLA). The top 20 stocks in terms of weighting also include Amazon.com (NASDAQ:AMZN), PayPal (NASDAQ:PYPL), and Nvidia (NASDAQ:NVDA), all of which are trading at big valuations. Combined, those four names account for nearly 8% of the index, per data from Slickcharts.com.
This is not to say that the S&P 500 is too expensive, or has ‘run too far.’ Rather, it’s simply to highlight that valuation concerns elsewhere in the market still exist here as well.
The History Problem
In October 1987, the stock market crashed, with what were then the two major indices (the S&P and the Dow Jones Industrial Average) both falling over 20% in a single day. The crash turned out to be perhaps the greatest buying opportunity in modern history. Over the next twelve and a half years, to the March 2000 peak, the S&P 500 rallied 582%.
That March 2000 peak came amid what is commonly remembered as the “dot com bubble.” But, in fact, optimism buoyed all stocks. From 1995 to 1999, the S&P climbed 220%. Its ‘worst’ year was 1999, when the index still gained 19.5%.
The returns haven’t been as torrid over the past five years, with the index up “only” 100%. But the broader picture looks awfully similar. From March 2009 lows, the S&P has rallied 457% in just shy of twelve years.
Certainly, investors could have argued in 2000 that the S&P 500 was safer. On a relative basis, it was. The NASDAQ Composite plunged an incredible 78% in a little more than two years. But the S&P 500 itself would lose nearly half its value over roughly the same timespan.
Understanding the S&P 500
To repeat, none of this is to say that investors should dump their index funds and race toward cash or investment-grade bonds (or bitcoin). It’s not to say that the market as a whole is in a bubble, or even necessarily overvalued.
Rather, the point is that the S&P 500 is vulnerable to the same downturns as other indices, even if the degree of potential decline is likely less. Similarly, it’s a reminder that the S&P 500 too is vulnerable to “irrational exuberance,” to use a famous late 1990s phrase.
And there are investors who see the current market as similar to, or even a repeat of, the high times of the late ’90s. For those investors, the S&P 500 might be more dangerous than it seems.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.
View more information: https://investorplace.com/2021/01/market-bubble-s-p-500-spared/