With cash yields near zero and safe bonds paying little more, many U.S. investors say they have no choice but to take more risk if they want to grow their money. While that may be true, investors also appear to be chasing the same investments in their quest for higher returns, stretching valuations and ratcheting up risk.
Notably, junk bonds, real estate and U.S. large-capitalization growth stocks are overrun with investors. Yields on junk bonds and real estate investment trusts are the lowest on record (yields and prices move in opposite directions). The U.S. stock market, which is dominated by large-cap growth stocks, is by most valuation measures more expensive than at any time except the peak of the dot-com bubble in 1999 — and by some measures it’s even more expensive.
The danger is that record high valuations have a habit of tumbling from their perch. There’s not much investors can do about junk bonds and REITs other than limit their exposure. But when it comes to stocks, there are many alternatives to large growth companies in the U.S., including small companies, value stocks and foreign markets. They’ve been horrible performers in recent years, leaving them cheap and unloved — which is precisely why they merit another look.
Small companies in the U.S. are as cheap as they have ever been relative to the broad market. The S&P 500 Index trades at a price-earnings ratio of 21.9, based on companies’ expected earnings for the current fiscal year, compared with 16.4 for the S&P Small Cap 600 Index. That spread of 5.5 points is only slightly smaller than the high recorded during the dot-com era. The same is true for U.S. value stocks. The P/E spread between the S&P 500 and the S&P 500 Value Index is 4.1 points, also the widest since the dot-com era.
The bargains are even better overseas. The MSCI EAFE Index, which tracks companies in developed countries outside the U.S., is 6.7 points cheaper than the S&P 500, the widest on record. And the spread between the S&P 500 and the MSCI Emerging Markets Index is 9.2, the widest in nearly two decades. Foreign value stocks are even cheaper relative to the S&P.
Top Shelf
Markets are smart, though, and when one asset is more expensive than another, there’s usually a good reason. When it comes to stocks, the reason is often that more expensive companies are also more profitable businesses. That shows in the numbers, too. Return on equity for the S&P 500 is 22.8, based on expected earnings for the current fiscal year, compared with just 9.9 for the S&P Small Cap 600. Like the P/E spread, that 13-point ROE spread is also among the widest on record. The same is true for value and foreign stocks. Their ROE relative to the S&P 500 is smaller than ever, or close to it.
But it turns out investors don’t have to chase the S&P 500 to capture its profits. The index is dominated by some of the best money-making machines ever devised, including Apple Inc., Microsoft Corp., Amazon.com Inc., Google parent Alphabet Inc. and Facebook parent Meta Platforms Inc., which account for nearly a quarter of the index. The tech giants, however, are not representative of the field. Most S&P 500 companies fall well short of the index’s headline profitability, if they’re profitable at all, and many of them are not cheap.