By Alejandro Saltiel, CFA
The current valuation of the S&P 500 index (SP500, SPX) is at 20 times forecast earnings. The chart below, from WisdomTree’s daily market snapshot, shows that this figure is above the 30-year median, but still within range. 1 standard deviation. Our senior economist, Jeremy Siegel, wrote that 20 times forward earnings is actually a fair multiple for the S&P 500 over time and corresponds to an earnings yield of 5% and an expectation of actual returns of five to seven years.
But it is certain that this multiple is higher than the long-term average and, given fears of a potential recession leading to the risk of earnings downgrades, higher-than-normal valuations are creating some turmoil.
S&P 500 Index Forward Price/Earnings Ratio
If we divide the S&P 500 into a broader technology basket, which includes the information technology sector, the interactive home entertainment sub-industry, the interactive media and services sub-industry, Amazon (AMZN), EBAY, ETSY and Netflix (NFLX), and an Ex-Tech basket, we can see that most of the value premium multiple is driven by Expanded Tech stocks. The Ex-Tech portion of the market trades about 10 P/E points below the tech basket.
This is important because the current market cap weighting of the Expanded Tech basket in the S&P 500 is at an all-time high of 39%.
S&P 500 Advanced Technology P/E Ratio
S&P 500 Ex-Tech Forward P/E Ratio
Concerns about valuations have led some to focus on strategies such as equal-weighting the S&P 500, which results in a greater bias toward mid-sized companies.
WisdomTree is a pioneer in fundamental weighting strategies. We seek to manage risks such as valuation and profitability inherent in market capitalization-weighted strategies.
In 2007, WisdomTree launched its Domestic Core Equity Fund Familyseeking to give investors broad exposure to various downsizes in the U.S. markets by selecting profitable companies and weighting them based on their earnings.
WisdomTree Basic Action Family
By rebalancing these strategies each year, the WisdomTree US LargeCap (PES), Average capitalization (EZM) And Small cap (EEA) The funds maintain valuations that are lower than the broader market and ensure that investors don’t overpay as markets rise.
Filtering negative employees
Eliminating unprofitable names can have a significant impact depending on the size of the company.
At the end of November, 23.4% of the weighting of the Russell 2000 index (RTY) was made up of companies with negative profits over the past 12 months. Although this figure is lower in the mid-cap space, it is still north of 11% and peaked around 20% in the months following the Covid pandemic.
% of weight among negative employees
Looking back 17 years, the group of negative earnings companies has significantly underperformed the broader benchmark, so the identification and systematic removal of these companies has had a significant impact and is one reason why WTMEI and WTSEI have outperformed their respective benchmarks since their inception in January 2007.
Returns since January 2007
In recent years, we have improved the national core equity indexes by creating the WisdomTree Core Equity Index Committee, which oversees the rebalancing of these indexes. The Committee ensures that the measurement of results used in the annual reconstitution reflects the recurring profitability of the company and verifies that the risk reduction elements of the methodology are correctly implemented. These risk reduction elements include limiting exposure to companies with above-average earnings risk, as well as actively limiting sector and individual security biases, thereby reducing active risk relative to the market .
We believe this systematic process represents an advantage over other index providers, such as S&P, which do not add unprofitable names to their indexes but do not verify profitability once a company is included in the index. ‘hint.
Improve the measurement of gains
One of the Index Committee’s areas of focus is a topic that has received increasing academic coverage in recent years: how traditional accounting measures fail to reflect the structure of modern businesses.
Technology and healthcare companies, among others, are investing heavily in Intangible assets such as research and development (R&D) to develop products, patents and other competitive advantages.
Since 1974, the Financial Accounting Standards Board (“FASB”) has required companies to spend on R&D, deducting it from their income statement for the fiscal year in which the expense is incurred. Companies that spend physical assetssuch as vehicles and factories, are permitted to capitalize these expenses and depreciate/amortize them throughout the life of the asset, spreading their expenses over multiple reporting periods.
The argument behind this is that tangible assets have a value that can be easily assessed, whereas intangible assets are more difficult (if not impossible) to assess. In a conservative FASB approach, intangible assets are not assigned a value on the balance sheet, unlike tangible assets.
All else equal, this distinction translates into higher profits for high-asset firms operating in the industrial, materials, and energy sectors and lower metrics for low-asset firms in the information technology and healthcare sectors. This may have significant implications in terms of eligibility and weighting for WisdomTree National Core Equity Funds.
WisdomTree rebalanced its domestic core equity funds after the December 13 close. Following their annual reconstitution, these portfolios trade at significant discounts to their broad benchmarks (even their value benchmarks).
As expected, the combination of earnings weighting, along with the previously mentioned risk reduction layer, results in premium features, with a higher overall return on equity (“ROE”) than their benchmarks. and significantly higher than value indices, even though they have competitive performance. or significantly lower P/E metrics.
Return on equity
Outlook for 2024
Heading into 2024 and due to their results orientation, WTMEI and WTSEI remain overweight in cyclical sectors relative to their broad benchmarks. Although lower rates have historically benefited companies with lower or even negative earnings, we do not expect rates to return to zero, making a focus on profitability and valuation important.
At the same time, WTEPS’s sector biases are contained, except for its slight overweight in financials and underweight in information technology, seeking to provide investors with basic exposure to constrained valuations and increased quality.
Alejandro Saltiel, CFA, Head of Indices, United States
Alejandro Saltiel joined WisdomTree in May 2017 as part of the Quantitative Research team. Alejandro oversees the company’s equity indexes and actively managed ETFs. He is also involved in the design and analysis of new and existing strategies. Alejandro leads the quantitative equity and alternatives analysis efforts and contributes to the firm’s website tools and model portfolio infrastructure. Prior to joining WisdomTree, Alejandro worked in HSBC Asset Management’s Mexico office as a portfolio manager for multi-asset mutual funds. Alejandro received his master’s degree in financial engineering from Columbia University in 2017 and a bachelor’s degree in engineering from the Instituto Tecnológico Autónomo de México (ITAM) in 2010. He holds the Chartered Financial Analyst designation.
Important risks related to this article
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