Are Stocks Overpriced?

We’ve written about the Magnificent Seven stocks being the force behind the market’s gains this year.

And in light of their eye-catching returns and the overall index’s compelling bull marketA period during which stock prices rise significantly from recent lows for weeks, months or years. performance, it would be understandable to ask: Are stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. overpriced?

The chart below shows two valuation measures for the S&P 500 index as well as its 10 largest stocks and the other 490-plus equitiesThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid. in the index.

The first measure illustrates that future earnings per share (EPS) for the 10 largest stocks in the S&P 500 is estimated at 18.8%. That’s an impressive yet arguably unsustainable rate. A more reasonable 11.5% is estimated for the index as a whole, and the figure is 9.8% for the index minus those 10 stocks. For historical context, the average annual EPS for the S&P 500 over the last 20 years has been 8.4%.

By that measure, earnings are expected to be higher than average over the next 12 months. However, given that we’re in a bull market and the economy is expanding (GDP growth was a higher-than-expected 2.6% in the second quarter of 2023), it’s no surprise that earnings have been robust and appear poised to grow.

The second valuation gauge we’ve charted is forward price-earnings (P/E) ratio estimates. This is a simple comparison of the price of a stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. or index against its earnings (price divided by earnings). The trend is similar to what we observed in EPS—the 10 largest stocks’ P/E ratios are inflated—but the ratios for the index overall and the index minus those 10 stocks are significantly lower.

In this case, the data points to the majority of the S&P 500 being fairly priced if not undervalued. The 25-year-average P/E for the entire index is 16.8, below the current forward estimate of 17.7. But once you remove the 10 largest stocks, the 490-plus remaining index components have a reasonable valuation of 15.3.

Given that the average bull market from 1929 onward lasted 1,011 days and generated a return of 114%, the fact that we’re only 280 days in with a 28% gain gives us confidence that opportunities remain for investors to see additional growth—at a reasonable price to boot. And even if the Magnificent Seven falter, or if the trend shifts to favor lagging segments of the market, today’s prices indicate that most of the market is a relative bargain.

We’re watching the trends closely to find growth opportunities and manage clients portfolios in this bull market. Are stocks overpriced? We’re not so sure.