Investment Strategy Brief:                     Valuation Aberrations

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

Equity markets have rallied into year-end, reflecting optimism that the Fed may be done with its rate hike campaign. The S&P 500 still sits below the all-time high set back in early 2022, but well above the October 2022 lows. However, the rally from the lows of this bear market has been a bit unique.

In particular, the year-to-date gains have been driven overwhelmingly by just a handful of stocks that have come to be known as the Magnificent 7. While the broad index is up more than 25% with a week left in the year, if you were to exclude the impact of those seven stocks, the return would be much more muted. That’s seven stocks in a 500-stock index that are responsible for the lion’s share of gains.

A byproduct of this dominance from mega cap companies is premium valuations. The five largest companies in the index trade at a sizable premium to the rest of the market. While it’s not the most extreme disparity of the last thirty years, it certainly appears far from normal. Those lofty valuations in part reflect great expectations for earnings growth in the years ahead, which may need to be reevaluated if that growth fails to materialize.

Some of the outcomes from this are just straight up bizarre. For example, the Magnificent 7 now represent a whopping 17% of global equity market cap. That’s more than the value of large and mid cap stocks in the U.K., Japan, France, China and Germany combined at 16.7%. Think about that for a second – that’s seven companies with a bigger impact than five entire countries, and these aren’t small countries either. That’s just a symptom of how extreme this market environment has been.

Those expensive valuations appear to be focused in U.S. large cap growth stocks, where much of the Magnificent 7 resides. Glenmede’s Global Expected Returns Model estimates that valuations there sit at the 87th percentile. However, not all equity markets are priced at such a premium, with large cap value, small cap and international equities plotting either closer to fair value or perhaps even slight discounts.

Small caps in particular have been getting some attention, as they enjoy more fair valuations at the 54th percentile. However, they tend to be more economically sensitive, underperforming their large cap counterparts during recessions pretty consistently over the past few cycles. As a result, it may be a bit premature to get overly constructive on small caps, especially as the risk of recession heading into the new year remains elevated. Speaking more broadly, the combination of extended valuations in the aggregate plus recession risk should warrant an underweight to equities in diversified portfolios.

So to summarize, this year has witnessed a rally in equity markets, largely propelled by the significant impact of a select group of high-performing stocks referred to as the Magnificent 7. These stocks, which carry premium valuations, exert a disproportionate influence on global equity indices, going so far as to surpass the market cap of entire countries. These premium valuations are most pronounced in large cap growth stocks, but not all equity markets exhibit such elevated pricing. Small caps appear to offer more reasonable valuations compared to their larger counterparts but are often more sensitive to economic conditions and may underperform during recessions. And overall, given the combination of stretched valuations and increased recession risk in the approaching new year, investors should underweight equities in diversified portfolios.

Thanks for listening! And please don’t hesitate to reach out with any questions.