Among the more popular measures used to judge the relative cheapness of the S&P 500 index is the cyclically adjusted price/earnings ratio, also known as the Shiller CAPE. This ratio is defined as the price of the S&P 500 index divided by the average inflation-adjusted earnings from the previous ten years. The most recent reading of 29 suggests an overvaluation of the index.

However, the assumption by the Shiller CAPE measure that the index valuation should eventually revert to its long-term mean has lost significance in recent decades given the changing composition of the S&P 500 index. In the early 1900s, the index was dominated by financials and transport companies. Today, it is dominated by IT and healthcare companies whose higher growth prospects justify higher average valuation levels. In short, the Shiller CAPE ratio is a flawed concept that has not identified major market turning points over the past 30 years.

Alternative indicators paint a more attractive picture

We therefore prefer to look at different valuation measures as part of our investment decision-making process. First, free cash flow has historically been a better indicator of prospective stock market returns across regions than earnings and tends to be a superior gauge of a company’s true financial health. Second, we prefer to look at the extent of the disparity in the valuations of companies within given sectors to detect valuation excesses. At present, we are close to long-term average levels, suggesting that markets are not rewarding a strong position one way or the other.

Lastly, in a multi-asset portfolio context, valuation is always a relative game, therefore, we factor in forward-looking equity risk premium estimates. A higher equity risk premium means that equities yield a higher expected excess return, making them relatively less expensive today. Currently, the US equity risk premium is close to its long-term median level, offering an excess return of 3.4%.

Forward-looking model suggests increase in returns

This estimate errs on the conservative side, since our in-house equity risk premium model is inherently more backward-looking given that it does not consider earnings growth expectations. Prof. Aswath Damodaran of the NYU Stern School of Business, who includes five-year forward earnings growth expectations in his calculations, arrived at an implied equity risk premium of 5.9% at the start of 2023. This implies an expected long-term average annual return of 9.8% on the S&P 500 index.

At current levels, the S&P 500 is trading around fair value, pricing in a normalisation of both growth and inflation.

Public markets: from cash-raising to cash-returning

From a broader perspective, we believe that the S&P 500 is deeply misunderstood. The amount of equity capital circulating around US public markets has been trending down since the early 2000s due to a secular decline in initial public offerings, coupled with delistings, and an increasing trend in share buy-backs. Overall, the S&P 500 has morphed from a cash-raising to a cash-returning mechanism.

The most freshly raised capital has been flowing into private markets recently. Given the sheer volume of capital flowing into the space, selectivity is even more warranted than before. This is reinforced by the fact that most private companies mainly rely on floating rate debt, which means that the transmission of monetary policy tightening will be faster and may not yet be fully reflected in the current valuations.

In contrast, the S&P 500 is relatively insensitive to interest rates, as the average maturity of outstanding debt is around seven years and almost 80% of the outstanding debt was financed at fixed rates. Moreover, only about 5% of fixed-rate debt matures each year in the current decade. If policy rates remain at current levels, the tightening may not begin in earnest until the end of this decade.

Do not underestimate the S&P 500

Over the past few decades, S&P 500 index companies, in aggregate, massively increased their ability to generate free cash flow. The ability to return capital to shareholders therefore also increased: the combined amount of dividends and share buy-backs as a percentage of revenues climbed from 4.7%, on average, during the 2000s to as high as 8% towards the end of the decade.

Moreover, investors pointing to an overvaluation of the S&P 500 are implicitly discounting a mean reversion of the secular surge in the free-cash-flow metrics of the index. This is unlikely, as it would require both a complete reversal of corporate tax rates back to 40% and a fully-fledged reversal of globalisation

In stark contrast to large caps, the profitability metrics of smaller companies have deteriorated dramatically over the past 20 years. Moreover, the financing structure of listed small caps is much weaker. According to a study by Empirical Research Partners, almost 40% of their total outstanding debt is rate-sensitive, compared with only around 20% for large caps.

Selling US large-cap companies not advisable

If the US Federal Reserve’s monetary tightening and the stress among US regional banks trigger a deeper credit crunch, the US economy might experience a soft recession. In this economic recession scenario, S&P 500 earnings would decline by 10%–15%, the equity risk premia would increase, and the S&P 500 index would decline towards the 3,000–3,500 level.

However, if investors want to protect their portfolios against such a scenario, shorting US large-cap companies is not the most effective strategy. Given that large public companies are likely to be among the last to lose access to funding, underweighting other equity segments that are relatively more dependent on access to external financing would be the more prudent choice.