Aggregate stock market valuation ratios have not been strong predictors of broad market returns in the short or the intermediate term. And yet, high stock valuations sit near the top of concerns cited by investors about the state of today’s equity markets.
However, this perception stems primarily from a subset of U.S. growth stocks. Investors should be careful not to throw the baby out with the bathwater by ascribing this characteristic to their general stock market planning expectations.
The poster child for high valuations — the so-called Magnificent 7 (Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia, and Tesla) — had an aggregate price-to-book (P/B) ratio of 11.89 as of September 30 (despite six of the seven having lower profitability than the S&P 500 Index). To put that in perspective, the average for the US market over the past 30 years is 3.05.1 The 7 comprise 23.9% of the U.S. Russell 3000 stock index.
The Magnificent 7 helped push up the P/B ratio of the tech-heavy Nasdaq Composite to a high of 5.21. Indices of the broader stock market, especially those with non-US stocks, have substantially lower valuations. For example, the global MSCI All Country World IMI Index P/B is less than half that of the Nasdaq. They comprise only about 10% of that global stock index.
Aggregate price-to-book ratios as of 9/30/2023
Source:Dimensional Fund Advisors. Indices are not available for direct investment. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. Frank Russell Company is the source and owner of the Russell Indexes. MSCI data © 2023.
What should we make of this valuation ratio data? A stock’s price represents the value of a company’s expected future cash flows discounted back to the present. So high valuations can result either from high expectations of future cash flows, low discount rates, or a mix of the two. It’s not possible to cleanly isolate cash flow and discount rate effects from the data. But to the extent that high valuations reflect low discount rates, it’s very likely expected stock returns will be lower going forward for planning long term goals and particularly for the Magnificent 7.
To the extent that widening spreads between indexes are attributable to increases in the discount rates for value stocks relative to growth stocks in particular, the implication is a higher realized value premium for planning purposes. However, much research2 suggests investors should be cautious using valuation spreads to methodically adjust holdings for asset allocation. While regression analysis provides evidence of a link between valuation spreads and subsequent value premiums realized, hypothetical timing strategies that methodically switch between value stocks and growth stocks simply based on the relative valuations spread fail to consistently outperform a simple buy-and-hold strategy.
What’s the planning takeaway? Investors demand different expected returns across stocks. Although spreads in valuations vary through time, the very large spread driven by growth stocks, especially in the U.S. should not be ignored. It’s reasonable to expect that securities with lower prices relative to market fundamentals should have higher expected returns for long term investment management.
While value premiums in the U.S. or internationally may not show up every day, or even for a decade, we believe maintaining a consistent allocation exposure with a value emphasis is the most informed approach and is more likely to be rewarded consistently. Our portfolio strategies are dimensionally structured to reliably capture the value premium whenever it appears, and to mitigate negative outcomes during inevitable periods of downward market adjustments.
1. Average P/B ratio for the Fama/French Total US Research Index from October 1998 through September 2023.
2. Wei Dai, “Premium Timing with Valuation Ratios” (white paper, Dimensional Fund Advisors, 2016).