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.
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.
 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
Source: Charts are sourced to Bloomberg L.P. and Purpose Investments Inc.
The contents of this publication were researched, written and produced by Purpose Investments Inc. and are used by Echelon Wealth Partners Inc. for information purposes only.
This report is authored by Craig Basinger, Chief Market Strategist, Purpose Investments Inc.
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