US mega tech is expensive, but may be unavoidable

The US stock market rally this year is so narrow that the S&P 500 index’s gains have been entirely driven by just a handful of stocks, which are now significantly more expensive than more than 95 per cent of the broader market.

The question for investors is, does that valuation chasm begin to close, and will it influence the market’s direction in the second half of the year as much as it did in the first?

While the gap is extreme, the short-term correlation between valuation and performance is minimal unless you are coming off the sidelines and allocating fresh capital, analysts say. Performance over the next year or so will likely be driven by other factors like positioning and interest rate moves.

Some of the numbers, however, are so startling they cannot be ignored.

The top four stocks in the S&P 500 by weight — Apple Inc, Microsoft Corp, Amazon.com Inc and Nvidia Corp — account for almost 19 per cent of the index’s entire $34.4 trillion market cap.

They are up more than 45 per cent this year, while the other 496 are up barely 2 per cent and the index as a whole is up less than 8 per cent.

According to Tajinder Dhillon, a Refinitiv analyst, the aggregate 12-month forward price/earnings (PE) ratio of the top four stocks is 31.6, compared with 16.4 for the other 496 companies and 17.9 for the index as a whole.

Keith Lerner, co-chief investment officer at Truist in Atlanta, calculates that the four stocks’ average 12-month forward PE ratio is around 42.0. That compares with the 10-year average of 49.6, and is only lower thanks to Amazon. The other three are all more expensive than before.

The average 12-month forward PE of the other 496 stocks is around 20.8, Lerner says, adding that a ‘harmonic’ valuation measure stripping out extremely low index weightings and high PE readings reduces it further to 16.3.

Whichever way you cut it, the mega stocks are extremely expensive relative to the rest of the market. The cheaper rump of the market that has essentially flatlined this year should be well poised to pick up the baton.

This may play out if the Fed can engineer an economic ‘soft landing’. Unemployment at a 50-year low and inflation cooling to a two-year low strengthen the soft landing argument, but caution is still trumping adventurousness.

“When you look below the surface the picture changes from very expensive to more reasonable valuation, but it still might not be compelling enough relative to the above-average macro risk,” Lerner said.

Crowded trade

“It’s going to require a broader market participation to drive the next leg higher,” Jablonski said, adding that he does not see it happening this year.