March 25, 2024

I’ve mentioned extreme stock market valuations before, and we seem to be in a similar situation now. A recent Wall Street Journal article showed how the S&P 500 is expensive using multiple valuation methods:

  • The price-earnings ratio is above its 10-year average.
  • The price-to-book ratio is above its 10-year average.
  • The premium over 10-year Treasurys is near its most expensive point in two decades.
  • The P/E growth ratio is below its 10-year average and above its 20-year average.
  • The cyclically adjusted price-earnings ratio or CAPE ratio is higher today than 96.0% of the time since 1881, only being higher in the late 1990s and 2021.

Digging deeper, it’s bizarre how Microsoft’s market capitalization is twice that of the S&P 500 energy sector, yet it generates half the yearly free cash flow of those energy companies. Yes, Microsoft is efficient with capital compared to energy companies and has a high valuation. But what would the world look like if Microsoft disappeared versus if those energy firms vanished? The former would be inconvenient while the latter would revert society to the mid-1800s.

The S&P 500 energy sector isn’t all energy companies, but the U.S. is the largest oil producer in the world. Microsoft isn’t the entire technology sector by any means. So, it seems the wealth created by big energy firms should be as valuable as software.

A decade ago, the S&P 500 was more diversified. The last few times the stock market became rapidly concentrated were 2000, 2007, and 2011.

Perhaps passive investing is to blame. Mindlessly buying an index regardless of fundamentals is how most people invest in their retirement accounts. It started in 1976, when Vanguard founder John Bogle created the first index fund. Today, 58.0% of all equity funds use a passive strategy.

But even Bogle said passive investing could wreck the market. And yet, every payday investors buy an increasingly expensive index, and the strategy grows.

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