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Why Investors Need Perspective Around the Magnificent 7 and Valuations Thumbnail

Why Investors Need Perspective Around the Magnificent 7 and Valuations

Tuesday, March 4th, 2024 

The stock market continues to reach new heights, driven by a stronger-than-expected economy and the largest technology stocks. In particular, Nvidia, a maker of graphics chips used in artificial intelligence applications, recently helped to push markets higher after it beat Wall Street earnings expectations. 

This has added to the gains made by the group known as the Magnificent Seven, which consists of fast-growing technology companies, many of which have market capitalizations of a trillion dollars or more. In this environment, some investors may be nervous that the market has risen too far, too fast. 

At the same time, other investors may have a growing fear that they are missing out. So, how do long-term investors stay balanced when markets have climbed so quickly?

The most important consequence of the bull market rally of the past year is that valuation levels are no longer as attractive. The S&P 500 gained about 27%, while the Nasdaq and Dow Jones Industrial Average rose 39% and 17%, respectively. 

As a result, the price-to-earnings (P/E) ratio for the S&P 500 is now 20.4, meaning that investors are willing to pay $20.40 for every dollar of expected earnings. While this is below its peak before the 2022 bear market and the historic high during the dot-com bubble, it is still well above its long-run average of 15.6. 

Not surprisingly, the P/E ratio of the Information Technology sector of the S&P 500 is one of the loftiest at 28.1.

Large technology stocks have propelled the market

Why are valuations important? Simply put, valuations are among the best tools that investors have to gauge the attractiveness of the stock market over the long run. 

Unlike stock prices on their own, valuations don't just tell you how much something costs, but what you get for your money. After all, holding company shares means you are entitled to a portion of its value, which ideally grows over time.

Valuations correlate with long-term portfolio returns because buying when the market is cheap improves the chances of success. It widens the margin of error while buying when the market is relatively expensive can drag future returns.

However, valuations are neither market timing tools nor do they explain all market movements. Instead, they are guideposts that help investors determine appropriate asset allocations based on their financial goals. 

As the following chart shows, most valuation measures are now well above their long-run averages, including price-to-book, price-to-sales, dividend yield, and more. This is partly because the underlying fundamentals are still catching up with the market rally. As sales grow, earnings improve, and interest rates stabilize, valuations could also begin to improve. 

So, higher valuations are not a reason to avoid stocks but a reminder to focus on diversifying both within the stock market and across asset classes.

Valuations have increased over the past year

Case in point: The rally in mega-cap technology stocks is a quintessential example of the importance of diversification across various sectors. Not only do diversified investors benefit from the returns experienced by the Magnificent Seven and the technology sector more broadly, but they also protect their portfolios from downside risk and position themselves to take advantage of growth in other parts of the market. 

Beyond today's valuations and returns, another concern that some investors have is that a small group of companies is having an outsized impact on the overall stock market. The simplest way to see this is to compare the standard S&P 500 index, which places a weight on each stock based on its size (market capitalization), to one that gives an equal weight to each stock. 

Both weighting methods are useful in different ways: using market cap weights provides a more accurate sense of the composition of the stock market - i.e., where the dollars are. Tracking equal-weighted indices helps investors gauge how each stock in the index is performing on average. 

Historically, stocks of all sizes have contributed to market returns

A "healthy" market is one that has broad participation, with a majority of stocks performing well. An "unhealthy" market is one that does not have broad participation in positive stock price momentum. 

These gauges are best captured through the equal-weighted market index. Lastly, investing in equal-weighted funds benefits from a broader base of companies to naturally diversify.

As the chart shows, it's not the case that large companies have always dominated stock market returns. For much of the stock market's history, the largest companies were often seen as the most boring (e.g., "blue chips") and primarily served as a source of stable dividends. 

Over the past 15 years, the equal-weighted S&P 500 index has actually outperformed the market cap-weighted index since it benefits from returns across a wider array of stocks. Although the largest companies have outperformed recently, zooming out reveals a different picture. Investors need to keep this in mind as they make capital allocation decisions.

The bottom line: With the market near all-time highs and seemingly driven by a small group of stocks, focus more on valuations and staying diversified. History shows that doing so can help you achieve your long-term financial goals regardless of market and economic conditions.

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Matt Faubion, CFP®

Founder - Wealth Manager

This article is for informational purposes only and is not a replacement for real-life advice, so make sure to consult your tax, legal, accounting, and financial professionals if you want more information. This content is developed from sources believed to be providing accurate information, and provided by Copyright (c) 2024 Faubion Wealth Management LLC, and Clearnomics, Inc. All rights reserved. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.