Not Your Father’s Stock Market
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Not Your Father’s Stock Market

Stop me if you’ve heard this one before: Stocks are expensive.

As the major U.S. equity indices have continued to reach new all-time highs over the past few months, this has been a topic on the minds of many investors, and reasonably so. As evidence of the pricey nature of stocks, it’s common to point to the current level of valuation measures, such as the price-to-earnings (P/E) ratio, relative to their historical levels. While it’s true that valuation measures are elevated relative to historical levels, this isn’t a true apples-to-apples comparison. Over the past few decades, the composition of the U.S. stock market has shifted away from lower-growth types of companies that carry lower valuations towards more innovative and growth-orientated companies.

In 1990, Information Technology was the smallest sector in the of the S&P 500, making up just under 6% of the index. For some historical perspective, it would be another 14 years until Google and 22 years until Facebook became public companies. Apple was around, but more than 15 years away from introducing the iPhone and transforming itself into the company we know today. Today, technology stocks make up more than 24% of the total market capitalization of the S&P 500, including four of the ten largest constituents of the popular index. While not quite as dramatic of a shift, the healthcare sector has grown from 8.4% of the index in 1990 to over 14% today.

The gain in share of for these two growth-orientated sectors has come at the expense of sectors that typically carry lower valuations, namely industrials, energy, materials, telecommunication and utilities. These five sectors combined to account for more than half of the S&P 500 in 1990, but now make up less than a quarter of the index.

As usual, a picture is worth a thousand words:

I’m not suggesting that stocks are cheap today based on the changing composition of the market, but it does account for some amount of the elevated valuations and is worth keeping in mind as we try to make comparisons with history.