Inflationary trends are receding, the economy remains resilient, and interest rates are expected to decline later this year. Historically, these “Goldilocks” conditions have been ideal for capital markets. The S&P 500 Index’s 4.7% year-to-date (YTD) advance (as at February 21), on top of a strong 2023, reflects this positive outlook. However, as occurred during parts of 2023, the average stock as measured by the S&P 500 equal weight index is up only 1.4% YTD, indicating that participation is concentrated amongst a narrow band of companies. Indeed, five companies (NVIDIA, Meta Platforms, Microsoft, Amazon, and Eli Lilly), driven mainly by excitement surrounding artificial intelligence, account for 66% of the S&P 500’s performance so far this year.

This suggests that the vast majority of companies in the index have yet to fully participate. While we maintain exposure to artificial intelligence-inspired themes in our portfolio, attractive valuation in other sectors bodes well for an expansion in market breadth. (All rates of return and valuation multiples in this newsletter are sourced from Bloomberg and are as of February 21, 2024. Returns are inclusive of dividends)

Momentum drives the short-term, but valuation ultimately prevails
Enthusiasm for various investments ebbs and flows based on investor appetite and evolving outlook. This is reflected in the range of valuation multiples at which stocks trade relative to one another and relative to each stock’s own historical levels. Excitement about a stock or sector’s outlook results in higher valuation multiples while investor apathy for other stocks leads to lower valuation multiples.

Momentum, both positive and negative, tends to get exaggerated in the short-term as fear and greed sway individual investor decisions. However, over time, valuation multiples tend to mean-revert. For example, Apple (AAPL) is currently trading at a 26.7x multiple of forecast 12-month forward earnings, even as its 20-year average historical valuation multiple has been 21x and the company has traded as low as 9x over this period. Similarly, Bank of Nova Scotia is currently trading at 9.6x expected 12-month forward earnings, compared with a 20-year average of 11x and a high of 14x.

It is difficult to predict how long momentum will last or what catalysts will trigger turning points. Stocks that are expensive can stay expensive much longer than expected, cheap stocks can remain cheap for an extended period. Knowing that we will rarely time it perfectly, we rely on valuation to guide our buy and sell decisions.

The distance to the summit is dependent on your starting point
Knowing current valuation is critical when gauging potential investment return and assessing downside risks. Fuelled by momentum in the technology sector and expectations of interest rate cuts, the S&P 500 is currently trading at a 20.3x multiple of expected 12-month forward earnings. Over the past 25 years, this prominent index of U.S. large-cap equities has traded at an average multiple of 16.5x. Except for the dot-com period of the late 1990s/early 2000s, when multiples got as high as 25x, and the 18-month post-COVID-19 period, the index has not sustainably traded higher than 20x over the past 25 years.

Putting current valuation in the context of historical ranges, and barring any material increase in forward earnings outlook, we think it is rational to conclude that downside risks outweigh upside return potential over the next 12 months for the S&P 500. Indeed, our analysis covering the past 20 years of S&P 500 data indicates that whenever the index has traded above a 20x multiple, forward 12-month returns have averaged less than 5%. In other words, potential gains are limited when the starting point is already high.

We expect lagging sectors to get off the bench and start contributing
Ten large companies, mainly in the technology sector, have been responsible for 66% of the S&P 500’s 32% return from the beginning of 2023 to February 21, 2024. During this period, the equal-weighted version of this index returned only 15%. A divergence this wide is uncommon, and our analysis indicates that over long periods of time these two indices have delivered almost equal returns (for the 30-year period ending December 31, 2023, the S&P 500 market capitalization weighted index generated an annualized return of 10.1% versus 9.8% for the S&P 500 equal weight index). While this divergence can continue in the near-term, we think the start of the interest rate cutting cycle should trigger an expansion in breadth.

Limited market breadth has resulted in valuation anomalies. Among the 11 equity market sectors, technology is trading at the highest absolute valuation multiple (27.5x) and at the largest premium to its 20-year historical average multiple (17.7x). Despite above average earnings growth prospects for the sector, momentum has pushed valuation to rich levels. Meanwhile, utilities, real estate, and energy currently trade at a discount to their respective 20-year average valuation multiples. These sectors may be out of favour for credible reasons, but valuation seems to be discounting the outlook. Other sectors such as consumer staples and banks are trading close to their long-term valuation levels.

Knowing that changes in momentum are hard to accurately predict, we are nevertheless interested in sectors of the market that have ample upside potential rather than segments already rubbing against their upper valuation bounds. As discussed below in the summary of recent transactions, we have trimmed our technology sector exposure and redeployed proceeds into fixed income where we expect higher than average returns as central banks start cutting interest rates. We believe we have adequate existing equity exposure across other sectors that should benefit from increased market breadth.