FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology

A small group of technology stocks have recently delivered stellar returns. Facebook, Apple, Amazon, Netflix, and Alphabet (Google), the so-called “FAANG” stocks, are up 36% on average year to date through September. This superlative performance, in such a narrow group of large cap names, has led many to raise questions about the current valuation of the S&P 500, its sector composition, and comparisons to other markets. These questions have included:

■ Do the old rules apply? The Information Technology (IT) sector, which has and deserves to trade at a higher multiple, is a larger part of the market today, so comparing today’s price multiples to history doesn’t make sense, right?

■ How can the market be expensive if no sector is trading at extreme valuations relative to its own history as measured by P/E 10 multiples?1

■ Isn’t the valuation gap of the US vs. non-US markets justified by the higher weight in IT in the US?

We know that the higher weight in the relatively expensive IT sector is driving some of the expensiveness of the S&P 500, but this does not fully explain the bulk of its high absolute and relative valuation level. In this short note, we’ll try to address some of the questions asked above.

Do the old rules apply to a “new” S&P 500?
The sector composition of the S&P 500 has changed meaningfully over the last four decades (see Exhibit 1). As we entered the roaring 1980s, the S&P 500 was dominated by lower-price-multiple, cyclical companies. The Energy, Materials, and Industrials sectors accounted for 45% of the S&P 500 while IT and Health Care made up 15% of the index. IT and Health Care’s weight has expanded to 38% today, while the lower-multiple cohort has declined to under 20%.

But that shift to higher-multiple sectors explains only a portion of today’s overvaluation as Exhibit 2 suggests. The blue line in the display plots the P/E 10 of the S&P 500 based on GMO’s bottom-up calculations.2 The red line is the long-term median P/E 10 of the market, essentially the “fair value anchor” for the S&P 500. Today, at 27.3x, the P/E 10 of the S&P 500 is quite elevated, trading 46% above its long-term median dating back to 1970. The static fair value measure, however, doesn’t account for the concern we’ve been hearing so much about recently – the changing sector composition of the market. Comparing today’s P/E 10 of the market to its long-term median valuation level makes the assumption that the level the S&P 500 traded at on average in the past is “fair” today. If index composition along some risk dimension one cares about, such as country or sector weights, changed over time, history might not be a very relevant anchor. Or so the argument goes. For any investor, such as GMO, who has considered the fair value of emerging markets, these issues are familiar and part of the assessment process given the dramatic changes the MSCI Emerging Markets index has seen in its country and sector membership over the last few decades.