October 6, 2023


S&P 500

Adam Gagas

Chief Investment Officer

October 3, 2023

The S&P 500 Index is often thought of as a proxy for the US stock market. In truth, the S&P 500 is an index that represents only a narrow slice of the domestic marketplace. Recently, the index is showing signs of getting even narrower by two important measures. While investors should be happy to participate in the performance so far, it reinforces our determination to maintain diversification to broader markets.

The 10 largest stocks of the S&P 500 now account for 33% of the value of the index, higher than at any point in the past several decades. Concentration means index returns are determined by the performance of just a few companies. When the list of the largest stocks also includes the best performers in the market, the effect is multiplied. For example, Nvidia (up +198% YTD), Facebook (+150%), and Tesla (+103%) together account for more than three-quarters of the year-to-date advance in the S&P 500 Index.

There is increasing concentration by valuation, as well. Investors are affording the largest companies a higher price/earnings ratio (P/E), indicating a willingness to pay more for every future dollar of earnings. For example, the P/E ratio for the handful of the largest stocks is 27.7, well above the historical average of 20.2. Moreover, that’s higher than the 17.6 assigned to the other 490 stocks in the index.

The same top 10 stocks aren’t contributing a larger share of earnings, however. Despite their above-average proportion in the total index, they are expected to contribute to total earnings in line with historical averages.

When the P (or Price) of the P/E ratio advances at a faster pace than the E (or Earnings) – driving the whole ratio higher – stocks experience “multiple expansion”.  With multiples already 30% higher than historical averages, there may not be room for the P/E to expand.  Future earnings projections will need to climb at a faster pace to justify current valuations.

So, what next? Earnings may accelerate and bring multiples back to historical norms. If not, valuation alone isn’t usually a cause for a decline in stocks, but above-average values may make them more sensitive to shocks. Sometimes stocks simply “tread water” while they grow into valuation. In any event, optimism for perpetual growth isn’t an unusual occurrence, and is the reason diversification into other parts of the market is an important part of well-positioned portfolios.

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