Maybe ETFs Aren’t the Reason You Can’t Find Any Stocks to Buy

  • Leuthold study shows the valuation curve across company size
  • P/Es were similarly harmonized before the tech bubble popped

You hear it a lot nowadays. Some active manager is struggling and claims the rewiring of the stock market by passive investors has made everything too expensive. There’s nothing left to buy, he says, and nowhere to hide should things turn south.

But blaming exchange-traded funds for the situation seems a little iffy, going by new research from Leuthold Weeden Capital Management. The reason: a nearly identical alignment of extreme valuations existed in American equities two decades ago, when index investing was still in its relative infancy.

Leuthold strategists considered the broadly elevated valuation profile of U.S. equities today and found a precedent: March 1998, when the dot-com bubble still had two years left to run. Sorting the stock market into 10 groups by median market capitalization, Leuthold found the “curve” of price-earnings ratios from megacaps down to penny stocks that year was nearly indistinguishable from the one now.

How strong is the resemblance? The decile with the smallest stocks fetched 18.3 times annual profit back then, versus 19.2 now, while the middle groups were all within less than a point of today’s values. P/Es in the biggest market-cap decile were slightly higher then, but not by much: 24 versus 22 today.

“For those who would argue valuations are up here because of passive flows, this is a devil’s advocate,” Doug Ramsey, chief investment officer at Leuthold, said by phone. “It’s more the fact we’re in a solid point of the cycle, relatively speaking. Earnings growth has rebounded nicely, and hence you get these broad overvaluations.”

For investors worried that high valuations guarantee trouble for the stock market, the data shows pricey stocks can get even pricier. The S&P 500 trades at a multiple of 21.5, compared with an average 24.7 during March 1998. From there, the benchmark gauge rallied another 29 percent.

But it also shows that the end of bull markets can be messy. While giant companies fueled the rally during dot-com years, pushing the capitalization-weighted S&P 500 up 27 percent in 1998 and 20 percent in 1999, the spoils weren’t evenly shared. Gains in an equal weighted version of the benchmark were half as large those years, and small caps actually fell in 1998.

“I don’t like to cast these broad valuation nets on the market,” KC Mathews, chief investment officer at UMB Bank in Kansas City, said by phone. “You’ll be short-sighted and get out of the market too early if you say, ‘valuations are this high, therefore I have to sell.’ You have to think about the environment we’re in and the one we’ll be in tomorrow.”

(Corrects Ramsey’s title in fourth paragraph.)
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