Perspective on the Magnificent 7 and Stock Valuations

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. As shown in the accompanying chart below, 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 so far, so fast. At the same time, other investors may have a growing fear that they are missing out.

How can long-term investors stay balanced when markets have climbed so quickly?

Large technology stocks have propelled the market

Perhaps the most important consequence of the bull market rally of the past year is that valuation levels are no longer as attractive overall. The S&P 500 has gained about 28% during this time while the Nasdaq and Dow Jones Industrial Average have risen 40% and 19%, 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 both its peak before the 2022 bear market as well as 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, which has been the main driver behind the S&P’s elevated P/E.

 

Why are valuations important to long-term investors? Simply put, valuations are among the best tools that investors have to gauge the attractiveness of the stock market over years and decades. 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 shares of a company means you are entitled to a portion of its value, which ideally grows over time. Valuations are correlated with long-term portfolio returns for this reason – buying when the market is cheap can improve the chances of success and buying when the market is relatively expensive can be a drag on future returns.

 

However, valuations are neither market timing tools nor do they explain all market movements. Instead, they are simply guideposts that can help investors determine appropriate asset allocations based on their financial goals. As the accompanying chart shows below, 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 begin to improve as well. Thus, higher valuations are not a reason to avoid stocks but are instead a reminder to focus on diversifying both within the stock market as well as across asset classes.

Valuations have increased over the past year

Case in point: the rally in mega cap technology stocks is an important reason to be diversified across a variety of 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 potential in other parts of the market. As investors know, past performance is no guarantee of future returns. Investors with longer time horizons should remain balanced across a variety of sectors and styles that are tied to trends in the underlying economy, even if they are invested more aggressively.

 

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. Perhaps 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, to one which gives an equal weight to each stock as shown in the accompanying chart below. 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. Using equal weights helps show investors a potential benefit from a broader base of companies to naturally diversify.

Historically, stocks of all sizes have contributed to market returns

As the accompanying chart shows above, it’s not always the case that large companies have dominated stock market returns. For much of the history of the stock market, 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 weight 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 in recent years, taking a longer perspective paints a different picture. It’s important for investors to keep this in mind as they make portfolio decisions.

The bottom line? With the market near all-time highs and seemingly driven by a small group of stocks, investors should still remain focused on valuations and staying diversified overall. History shows that doing so can help investors to achieve their long-term financial goals regardless of market conditions.

 

 

Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC. Advisory services offered through Sanctuary Advisors, LLC., a SEC Registered Investment Advisor. Tenet Wealth Partners is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC. The information provided in this communication was sourced by Tenet Wealth Partners through public information and public channels and is in no way proprietary to Tenet Wealth Partners, nor is the information provided Tenet Wealth Partner’s position, recommendation or investment advice. This material is provided for informational/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Investments are subject to risk, including but not limited to market and interest rate fluctuations. Any performance data represents past performance which is no guarantee of future results. Prices/yields/figures mentioned herein are as of the date noted unless indicated otherwise. All figures subject to market fluctuation and change. Additional information available upon request.