To value securities, or an index, on cash flow, we like to use free cash flow, or cash flow left after operating expenses and capital investments relative to price. By this measure, the S&P 500 is trading at a multiple of 23, about two points above the 5-year average and six points above the 10-year average (Figure 3). As a result, based on cash flows, we would suggest valuations are on the high side but not extreme.
Similar to our assessment of P/E ratios, cash flows have been somewhat depressed during the post-pandemic inflationary period and may have more upside than they typically do. Further, the S&P 500 is less capital intensive than it used to be. In fact, one could argue that nearly half of the index reflects the digital economy—roughly 30% technology, 9% communication services, 5% internet retail, including Amazon (AMZN) and others, and even a couple points of digital payments (within financials) and digital healthcare.
These are generally more “asset-lite” business models with higher returns on capital. In fact, returns on capital for the S&P 500 have moved significantly higher, even since the productivity boom and economic “digitization” in the late 1990s (Figure 4). This profit stream from a more profitable, less capital-intensive corporate America is worth more, which is likely a key reason why higher valuations have been sustained the past several years and may remain elevated.
Summary
So, even with the S&P 500 at record highs, 19% above the October 2023 low, and up nearly 40% since the current bull market began in October 2022, LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its neutral equities stance.
The STAAC continues to favor a tilt toward domestic over international equities, with a preference for Japan among developed markets, and an underweight position in emerging markets (EM). The STAAC recommends a modest overweight to fixed income, funded from cash to enable the neutral equities position.
Jeffrey Buchbinder, CFA, is chief equity strategist at LPL Financial.
Stock valuations are on the high side by most commonly used metrics, whether based on earnings or cash flows. When considering interest rates, they look more reasonable. When considering earnings have been somewhat depressed by inflation and are poised to accelerate in 2024, especially if the U.S. economy delivers that sought-after soft landing, paying higher valuations for stocks feels less uncomfortable. Add the fact that the digital economy has lifted returns on capital because of higher profit margins and less capital-intensive business models, and the argument that valuations are fair garners more support. Finally, consider valuations are not good timing tools from year to year, and the risk-reward trade-off between stocks and bonds still looks balanced to us.