S&P 500 market index crashed in March 2020 and plunged by 34% from the level in Feb 2020. However, S&P 500 have quickly rebounded and it is now trading at 7.5% higher than the level in Feb 2020. The vaccines news further skyrocketed the market and reached an all time high. It is considered an expensive and highly risky market to invest on. Is S&P 500 really overvalued and should I stop investing in it.
Let’s analyse the valuations and other considerations.
CAPE Ratio of S&P 500
Cyclically-adjusted price to earnings (CAPE) ratio is an important valuation. It indicates if the market index overvalued or not by comparing to its historical value.
PE ratio is commonly used to analyse a value of an index or stock but it is calculated using one year’s earning.
Whereas, CAPE ratio is calculated using average earnings for 10 years period. It is calculated by diving the latest share price by average earnings for the last 10 years and it is also adjusted for inflation.
The average CAPE ratio for S&P 500 index is 16. The S&P 500 index currently has a CAPE ratio of 33 which is above the 40 year’s average CAPE ratio.
This valuation indicates that S&P 500 is overvalued. However, there other considerations suggest it is not overvalued comparing to the past.
CAPE ratio valuation during the dot com bubble was 44 is much higher than the current valuation of 33.
Currently S&P 500 valued higher based on tech stock (FAANG) similar to the tech bubble in 1999. However, the difference is the tech companies during dot com bubble had less sales with no profits. Whereas, the tech stock results in Q2 2020 have produced an high return on assets and huge profits.
The balance sheet of these tech companies are extremely strong and cash rich (each of the tech companies sitting on huge cash expect Tesla). These companies are delivering innovating products and it is largely contributing to maintain a strong balance sheet.
Even though US stock market is surging forward and seems overvalued. However, when accounting for the low interest rate, S&P 500 valuations are not that higher as it seems to be. Federal reserves have confirmed this on their semi-annual financial stability report.
The report also tells that taking risk in S&P 500 stock market is compensating in line with historical norms. However, the volatility and uncertainty remains risk.
A large number of companies in the entire US equity market is still trading below of the levels in Feb 2020. There is some opportunities for these value stocks to move upward.
US GDP have seen both the worst and best in the history with 31.4% drop in Q2 2020 and a stronger recovery of 33.1% (Advance estimate). It is the fastest pace the US GDP has grown in Q3 2020 in the US history. This growth would slow down as fascial support and stimulus is coming to an end. However, the vaccine hopes may bring the virus spread under control and this would support continued recovery of the economy.
U.S. manufacturing PMI for October 2020 is estimated as 53.4 by IHS Markit. It is a strongest growth since Jan 2019 and a consecutive growth for the fourth month in 2020. It is a strong recovery from the levels in April 2020. This growth is contributed by high level of order inflow and a strong demand from the customers.
The unemployment rate in the US have fell to 6.9% in October 2020. Although, it is still higher than the level before the pandemic in Feb 2020, the recovery is better than expected estimates by analyst.
All the valuations metrics such as CAPE ratio, price-to-earnings, and price-to-sale ratio indicates that S&P 500 market is overvalued. But other consideration such as low interest rate and growth of US economy suggest that S&P 500 market is still a potential opportunity to bet on.
For an 100% passive investor, it is always recommended to stay invested in S&P 500 in all conditions of the market. However, you can reduce the risk by rebalancing your assets back to your desired allocation.
For instance, if you have had £60k in equity and £40k in bonds at the start of the year and your desired asset allocation is 60:40.
Let’s assume at the end of the year, your portfolio has £150k in equity and £50k in bonds. This means your portfolio has 75% in equity and 25% in bonds.
Hence, you should sell the best performing asset, in this case equity, and invest that amount in worst performing asset which is bond. In the case of our example, you should sell £30k (15%) of equity and invest it in bonds to adjust it back to desired asset allocation 60:40.
Rebalancing should be done at a regular interval (let’s say once a year or when your asset allocation of portfolio deviates by certain percentage, for instance 10%). This will not only optimise your profits but also reduces your risk exposure.