Gordian Knot Unwinds in S&P After 4 Years of Lockstep P/Es

  • A measure of dispersion bounces back from record low readings
  • The same thing happened at the end of two other bull markets

A quirk of valuation that has paralyzed stock pickers for four years is loosening its grip, though investors might not like what happens afterward.

It’s the degree to which one company in the S&P 500 resembles all the others in terms of price-earnings ratios, a quantity expressed as dispersion by market analysts. After holding at record levels for much of the bull market, now it’s easing off, with a Goldman Sachs Group Inc. index tracking differentiation snapping back to average levels.

Valuation clustering and its causes are the basis for rampant theorizing on Wall Street, with everything from the homogenizing influence of exchange-traded funds to central bank stimulus held up as culprits. What’s less open to debate is what has happened to investors after P/Es fell out of lockstep in the past. Broadening multiples preceded bull market peaks in 1998 and 2007.

“What you’re starting to see is a delineation of fortunes,” said James Abate, who helps oversee $1 billion as chief investment officer at Centre Funds in New York. “There are fewer and fewer companies that are able to demonstrate attributes that are critically important to maintaining valuation, while a small segment of the market continues to do very well.”

Spiking P/Es among energy companies, whose shares haven’t fallen enough to match the plunge in earnings, are responsible for a lot of the widening, though other industries have seen valuations evolve since April 2014, when the measure reached its tightest in more than six years. Shares of industrial, phone and health-care companies have gotten cheaper, while multiples in consumer staples and utilities rose.

The easiest way to see the shift is to look at the market from the bottom up. In 2014, the industry with the lowest P/E was banks, trading at about 18 times earnings -- the highest multiple ever for the S&P 500’s cheapest group. Now it’s telecom, trading at a price multiple of 14 at the end of April, close to the median since 1990, according to Leuthold Group data compiled on a monthly basis.

Even as S&P 500 valuations have spread out, one thing has remained constant: prices are expensive relative to history. Two weeks ago, the P/E ratio for the benchmark index reached 19.53, the highest in more than six years. The S&P 500 fell 0.2 percent to 2,046.44 at 11:44 a.m. in New York, extending a 1.7 percent skid over four days.

One feature that contributed to the clustering is the bull market’s unprecedented breadth. Since March 2009, a version of the S&P 500 that strips out biases related to market value, effectively a way of tracking the average stock’s performance, has rallied about 80 percentage points more than the normal, capitalization-weighted index.

U.S. stocks have benefited from a multi-year run of positive news that supported lofty valuations and lowered investor risk aversion, according to Jason Hsu, chairman and chief investment officer of Rayliant Global Officers, which oversees $25 billion in Hong Kong.

“We are probably near the top of the earnings cycle and near the top of a market cycle, which means we’ve only had very good news,” Hsu said in a phone interview. “Whether it was earnings growth, whether it’s a reduction in the unemployment rate, whether it’s lower risk experienced by various sectors of the financial market -- we’ve just been in a period of good times.”

While the market has had wind at its back, not everyone is convinced economics tell the whole story. The rise of investing vehicles such as ETFs, where individuals can buy every stock in an index with one phone call or push of a key, works against differentiation, they say. Such effects are the subject of a larger body of academic research and recent blog posts examining the impact of passive investing on the market.

“There’s an old theory which says that if everybody’s indexing, nobody’s minding the store,” William Goetzmann, a finance and management studies professor at Yale University and Pulitzer Prize-winning author, said in a phone interview. “Nobody’s actually doing the research to find out if stocks are correctly valued. So if everybody indexes, then valuations could be extremely misleading, and the market could be very inefficient.”

A measure of the dispersion of price-earnings ratios in the S&P 500 compiled by Goldman Sachs widened to 55 percent at the end of February, matching its average level since 1990. At its tightest, the gauge got to 42 percent in October 2006, a year before the last bull market ended, Goldman Sachs data show. Before that, multiples were most compressed in September 1997, 10 months before a 19 percent plunge in the S&P 500 began.

Goldman Sachs’s price-earnings ratio dispersion is a monthly reading of standard deviation, or the variance from the average, for companies in the S&P 500. Goldman Sachs compiles data for companies whose price-estimated earnings ratios are between zero and 75.

The degree of dispersion in the market varies according to methodology. Analysts at Credit Suisse Group AG try to eliminate the impact of accounting variables and measure clustering by focusing on cash flows. Their models show valuation dispersion remains relatively low compared to history, David Rones, director at Credit Suisse HOLT in New York, said by phone.

“We got here via massive expansion in the valuation of the market, to some extent driven by monetary stimulus,” Rones said. “I guess you could reverse it and say a rapid tightening or a big step increase in interest rates could cause people to be much more particular about how they price securities and force a wider dispersion.”

Jason Pride, the Philadelphia-based director of investment strategy at Glenmede, which oversees $30 billion, says ETFs only impact short-term stock fluctuations and don’t have much effect on long-term valuation.

Low interest rates cultivated by the Federal Reserve throughout the seven-year bull market are also partially responsible for the low valuation dispersion seen during the period, according to John Carey of Pioneer Investment Management Inc. Without much yield competition from Treasuries, all groups of stocks were able to boost their valuations in tandem, he said.

“Interest rates were so steady for so long that the multiple range settled down into a rut,” said Carey. “Likewise, the economy has been very moderate in its growth over the last couple of years, so we didn’t get the kind of variability that sometimes leads to relative moves in different parts of the market.”

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