The Rising Cost of the S&P 500

The S&P 500 has seen an increase in its valuation, largely due to significant profits in recent years. It seems that the current indexes are increasingly focused on growth, which, in turn, supports the argument for a higher valuation.

This particular setup of the S&P 500 leads to a situation where it feels less diversified, potentially heightening volatility in the market.

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Exchange-Traded Funds (ETFs) can be a cost-effective way to gain exposure to various stock baskets. For instance, the Vanguard S&P 500 ETF holds more than $1.5 trillion in assets, making it the largest fund under the S&P 500—larger even than the iShares Core S&P 500 ETF and the SPDR S&P 500 ETF Trust.

Currently, the Vanguard S&P 500 ETF is at an all-time high, having increased by 8.5% annually since its launch in 2023, leading to an impressive total increase of 66.4%.

Some might argue that the S&P 500 isn’t as overpriced as it appears, and there are reasons suggesting it could be an excellent investment choice.

A good way to assess the S&P 500’s valuation is by comparing the index price rises to the changes in earnings per share (EPS). Operating profit stands out as a more reliable metric since it excludes one-time fees or earnings that might not accurately reflect a company’s true performance.

If we look at how the S&P 500 trades over various timeframes, it’s clear that the index is experiencing faster growth than its operating revenues, leading to higher valuations. In essence, companies in the index are becoming relatively expensive based on their actual performance.

Another approach to gauge the S&P 500’s rating involves looking at future revenue forecasts. The forward price to earnings (P/E) ratio calculates current prices against analyst projections, rather than just focusing on the next 12 months. As of August 1, the forward P/E ratio was recorded at 22.2, compared to a five-year average of 19.9 and a ten-year average of 18.5. This indicates that the S&P 500 trades at a 20% premium over its ten-year average. It certainly gives the impression that the index might be very much overrated—but perhaps there are logical reasons for this rising valuation.

As time goes on and companies become more efficient, both the S&P 500 and individual companies could see rising valuations.

With a majority of growth-focused companies making up the index, it stands to reason that S&P 500 ratings will likely increase in the long run. Instead of using profits to buy back shares or pay dividends, firms that reinvest their earnings can earn a higher valuation as those investments yield returns.

It may not be ideal to focus simply on whether the S&P 500 reflects an “average” over the last decade. One shouldn’t hastily conclude that it is overrated without understanding the reasons behind its current valuation. Likewise, misjudging the risks currently in the market could be misleading.

The influx of high-growth companies elevates S&P 500 revenues and projected growth rates, although this also adds to market volatility. For example, a downturn in technology investments could have a bigger effect on the S&P 500 now than when tech had a lighter index weight.

It seems justified for the S&P 500 to have a higher valuation than historical norms, suggesting that ETFs tracking this index might not be as costly as one might think. However, due to its structure, one should be ready for significant fluctuations in the index’s performance.