Do Valuations Matter?

For the S&P 500, the quartile of companies that were trading with the lowest valuation at the start of 2023 enjoyed an average return of 8.9%. Not bad. But the companies with the highest valuations returned 17.7%. It's not just within U.S. equities that it may appear valuation doesn’t matter. Emerging markets have been trading at very low valuations for years and have consistently lagged developed markets. Based on the Bloomberg Developed (DM) and Emerging (EM) markets indices, the spread is wide at about 18x vs 12x. Also of interest is that EM earnings are expected to grow at 28% compared to 18% in DM over the next couple of years. Or the TSX at 14x compared to 20x for the S&P, a long-standing valuation spread, yet the more expensive S&P keeps winning.

Now, comparing one market's valuations to another is like comparing apples and oranges. The composition of the market and different sector weights can often explain much divergence in valuations. For instance, the S&P currently has a 30% weight in technology, often a higher multiple sector. That compares to under 10% for the TSX. The S&P has more consumer staples, more health care, less energy, and less financials compared to the TSX. Staples and health typically carry higher valuations than the more cyclical energy and financials.

Yet valuations do matter. The chart below uses S&P 500 data back to 1950 and calculates the average performance for the S&P 500 based on starting point valuations. It is rather clear that higher valuations equate to lower returns going forward, on average. And that is the crux: averages can hide a lot of data. Sure, the average return from a starting point in the most expensive quartile bucket is rather close to zero, yet the one-year return ranges from +39% to -38%. That is rather wide. The 3-year return ranges from -17% to +18%. So, even though valuations are high, anything can happen.

Worth noting, the range of performance outcomes when the starting point is cheap (less than 11.4x), are rather compelling. The 3-year annualized worse case was flat, and the best case was +26%. Today, though, we are not in the bargain basement; we are in the valuation luxury penthouse.

Pushing the S&P 500 up to the penthouse of valuations is the Mag 7 or Enormous 8, or whichever funny label you prefer for the megacaps sitting atop the index. The concentration in the S&P 500 is at or near historically high levels, which is also pushing the valuation to the upper levels.  To give an idea, the chart below shows the relative valuations of the S&P 500 (traditional market capitalization-weighted version) and the Equal Weight S&P 500 index. It is those megacaps making the S&P 500 expensive; the broader market is not nearly as elevated.

Final thoughts

The Enormous 8 could very easily become more enormous in 2024, which would once again drive the most expensive part of the market higher. The average PE across the Enormous 8 is currently 36x forward earnings, but as we learned in 2023, a high starting valuation doesn’t guarantee anything as, in the short term, anything is possible. However, given concentration and given valuations, the odds are likely tilted in the other direction. Don’t lose sight of valuations; in the long run, they are one of the best indicators of performance and can offer a margin of safety.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

Get the latest market insights to your inbox each week.

Sources: Charts are sourced to Bloomberg L. P.

The content of this document is for informational purposes only and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document, and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable; however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently, and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are, by their nature, based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.