There’s a lot of mystery around the S&P 500 and what the metrics really mean, and this post is focused on shedding more light on the topic, including whether the S&P 500 is overvalued now and where things are headed in the future.
The S&P 500, being a market value weighted index of the 500 largest companies by market capitalization listed on US Stock Exchanges, is often used as the benchmark for financial performance and most commonly described as the “market.”
At the time of this writing, fundamentally speaking, the earnings yield of the S&P 500 is roughly 3.6% with the 10-year treasury note (considered the risk-free rate of return) yielding 4.295%? This formulates a negative value for the equity risk premium, meaning the investor is theoretically losing money (relative to the risk-free rate of return) by taking risk in equities. Similarly, the dividend yield of the S&P 500 is roughly 1.37% with the 10 YR Note yielding 4.295%? The cost of capital is more than 3 times the return on capital.
Furthermore, the dividend yield of the S&P 500 is at the lower end of its historical range with investment grade and junk bonds also trading at a fairly normal spread above the 10 YR Note yield. Thus, relative to the risk-free rate of return, its own historical dividend yield profile and other asset classes the S&P 500 is very overvalued. It is important to understand that valuation is a poor timing mechanism in the short term as market prices are buoyed more by the popularity of issues and pervasive sentiment governing markets.
When gauging market sentiment, the current value of the VIX being 14 suggests low uncertainty, but still far from terminal values in a range around 10. The PUT/CALL Ratio is lower than historical, but it does not show excessive optimism or having reached terminal extreme values.
When our proprietary technical analysis suggested the market price had reached a terminal extreme with strong pools of institutional resistance at the end of December, we took some profits. Subsequently, when the market price action triggered a well specified breakout above 4800, we identified a probability over the medium/long term that the SP 500 could grind its way to 6100 and become extremely overvalued along the way.
On the flip side, if market calamity strikes, we also see a probability the market price could test institutional pools of support around 4800 and 3500 on the S&P 500. In the event of extreme market uncertainty and a severe bear market, we anticipate long term institutional pools of support around 2150.
Presently the market price appears to be in an uptrend that is mildly strengthening yet has not reached a terminal extreme. As long-term investors in a very overvalued market, we retain a market neutral stance staying invested in the S&P 500 using prudent risk management.
Now this market neutral stance could change in a timely way for a multitude of reasons especially if the 7 largest stocks in the index (Magnificent 7) that have been responsible for the outsized performance of the S&P 500 begin to break down at some point. When we apply proprietary technical analysis to the Magnificent 7 stocks it appears MSFT, NVDA, AMZN and META have reached their terminal extremes, where the strength of the trend is becoming directionally unsustainable and a reversion to the mean is becoming more probable.
If your hedge fund, family office or other financial institution needs guidance on creating customized, data-driven approaches to investing in the S&P 500 we are here to help, and only a click away. Let’s Connect.