Identity Crisis in S&P 500 as Valuations Narrow Near Record

Sep 02, 2014 4:13 pm ET

(Updates with today’s trading in ninth paragraph and Morgan Stanley forecast in 18th paragraph.)

Sept. 2 (Bloomberg) -- The Standard & Poor’s 500 Index, one of the most diverse benchmarks for stocks in America, is starting to resemble a collection of clones.

Three years of virtually uninterrupted gains for the U.S. gauge have resulted in 77 record closes since 2012 and a valuation quirk that some see as a sign of indiscriminate buying. A measure of how much price-earnings ratios among the 50 biggest companies vary has fallen to almost the lowest on record, data compiled by Bloomberg show.

Gaps between stocks shrunk after investors shifted money out of higher-valued technology and Internet companies and bought defensive industries such as consumer staples and utilities. Such rotations, which can be done with a click of a button using exchange-traded funds, show buyers are making too few distinctions among good and bad companies and could exacerbate selling once it begins, said Eric Schoenstein, co- manager of the $5.2 billion Jensen Quality Growth Fund.

“There is less interest in trying to actually pick stocks versus just investing in markets,” Schoenstein, who is based in Portland, Oregon, said in a phone interview on Aug. 28. “If there were another 2008 somewhere on the time horizon, the fact that everything moves in lockstep up means they’d probably drop in lockstep down. That’s going to be very painful if that were to happen.”

Valuations for companies from Merck & Co. to PepsiCo Inc., whose steady earnings have traditionally made them defensive havens when the economy slows, are converging with those with at least twice the profit growth, such as Qualcomm Inc. and Apple Inc.

Not Normal

Price-earnings ratios among the 50 largest companies in the S&P 500 deviate from the mean by an average of about 22 percent, nearly the narrowest on record, according to data since 1990 compiled by Bloomberg. The study includes companies with a valuation multiple above zero and strips out the two highest each year.

“In theory, stocks shouldn’t be valued as similarly as they are,” Hayes Miller, the Boston-based head of multi-asset allocation who helps oversee $57 billion for Baring Asset Management Inc., said in an Aug. 27 phone interview. “It’s not a normal or sustainable situation.”

The last bull market ended with multiples in a cluster. In 2007, the deviation in price-earnings ratios for the 50 largest companies in the S&P 500 was about 25 percent from the mean. That’s the lowest level since at least 1990, the beginning of a decade when the average deviation was 37 percent. The index lost more than half its value in the next two years.

The S&P 500 fell 0.1 percent at 4 p.m. in New York.

Lacking Distinction

Valuations were the most spread out near the peak of the Internet bubble, when technology shares commanded a premium. The deviation from the mean was 57 percent in 1999. The S&P 500 peaked the next year and plunged 49 percent through October 2002.

“The same kind of lack of distinction being made in the late 1990s occurred in only one area of the market, the dot-com boom,” Scott Clemons, the chief investment strategist at Brown Brothers Harriman Private Banking in New York, said by phone on Aug. 27. The firm oversees $28 billion. “People are buying stocks for the sake of buying stocks.”

The proliferation of ETFs, which invest in a basket of shares, makes it easy to accumulate large positions without regard to the individual companies. The ETF industry has exploded in recent years, with assets tied to American equities reaching $1.1 trillion.

Cash Churn

Cash churning in and out of the funds will narrow valuations in the stock market over time as investors choose to transact in swaths of shares, rather than evaluate details such as company earnings, according to Brent Schutte, senior investment strategist at BMO Global Asset Management. The firm has over $240 billion.

In March, technology ETFs absorbed $970 million and investors pulled cash out of safe-haven groups. That trend reversed in the next two months, with cash coming out of computer funds and into utilities and consumer staples.

“In the 90s, everyone was a stock picker,” Schutte said in a phone interview from Chicago on Aug. 28. “Fast forward to today, what’s everyone’s calling card? They do strategic asset allocations and they buy index funds.”

In this bull market, unlike the dot-com boom, stocks from almost all industries are climbing. An average of 380 companies in the S&P 500 rose in each of the last five years, compared with 307 in the 1990s, data compiled by Bloomberg show.

Better Balance

“There are lots of companies and industries doing very well, so the market doesn’t feel the need to price one group much higher than everything else,” Doug Foreman, Los Angeles- based chief investment officer at Kayne Anderson Rudnick Investment Management, said by phone on Aug. 27. The firm oversees about $9 billion. “It’s much better balance.”

Morgan Stanley forecast continued appreciation for the S&P 500. A slower though sustained period of growth could help the equity benchmark peak near 3,000 by 2020 amid continued economic strength in the U.S., the bank wrote in a report today.

Merck, the second-largest U.S. drugmaker, trades at 17.2 times profit and analysts forecast profit will be little changed in 2014, according to data compiled by Bloomberg. The valuation matches Qualcomm, a company with estimated earnings growth of 32 percent.

Apple’s faster growth isn’t being rewarded either. The iPhone maker has a price-earnings ratio of 16.6, compared with 20.8 for PepsiCo. Analysts predict Apple will boost income by 14 percent this year, versus a 5 percent pace for the maker of soda and Frito-Lay snacks.

“There’s a whole group of stocks in growth purgatory,” Todd Lowenstein, who helps manage $16 billion at Highmark Capital Management in Los Angeles, said in an Aug. 27 phone interview. “Your returns from here are going to be less about multiple expansion and more about the fundamentals.”