Last week stocks took a beating as rising COVID 19 cases worried investors that state economies could possibly have to take a step backwards. At the time of the writing of this post today, stocks are rallying, but even before this rally, the stock market was overvalued. JP Morgan, one of the Portfolio Strategists we utilize for client accounts, wrote this about the S&P 500 in their Weekly Market Recap today…
Year-to-date, the S&P 500 is up 1.2%, but this performance hides a large dispersion between the top names and the remaining stocks. Specifically, U.S. markets have been led by a handful of growth companies, which have benefited the most as we shifted from our daily commutes to the office to working from home. As a result, the five largest names of the S&P 500 by market capitalization have returned 38.6% so far, while the remaining stocks are down 4.8%. Additionally, the strong run from the bottom seen in March has boosted the P/E ratio of the S&P 500 to the its highest level since the tech bubble. As shown in this week’s chart, the P/E ratios of the overall S&P 500 index and excluding the top 5 names have tended to track each other in the past, but a gap has emerged recently.
While the valuation of the overall index is significantly above its average since 1996, the P/E ratio of the index excluding the largest stocks is only modestly more expensive than its history. This suggests that there are potentially more attractive stocks outside of the mega-cap ones, highlighting the importance of active management to identify the right opportunities.
With the S&P 500 overvalued, there is also a higher risk of a stock market correction to get back to more reasonable valuations. This could be triggered by any piece of negative news with economic implications. However, it is also possible that if the economy continues to heal that company profits catch up with the market and valuations improve. Time will tell.