The prevailing view across the asset management industry is that U.S. equities are currently trading at elevated valuations. For example, the iconic S&P 500 Index, widely regarded as the best gauge of large-cap U.S. equities, is currently trading at 1.93x price-to-sales, a level that according to the regression analysis below, has historically corresponded to muted future returns. Exhibit 1 shows future 10-year annualized returns associated with different price-to-sales ratios. High price-to-sales ratios indicate lower long-term returns.
Investors may be able to rationalize today’s high valuations given the low interest rate and benign inflation environment, but nonetheless will have to adjust future return expectations lower. Investors today face two choices: accept lower return expectations or build a lower valuation portfolio that has higher return expectations.
Why the S&P 500 Index Appears Overvalued
We’d argue that the S&P 500 Index’s elevated valuation tells you more about the construction methodology of the index than it necessarily does about the current value of each of the underlying securities. The primary issue with market-cap indices is not with the stocks they hold, but rather with the weightings those stocks are assigned. Since market-cap-weighted indices are price driven, they give the highest priced stocks the largest weightings, and the lowest priced stocks the smallest. As former U.S. Federal Reserve Chairman Alan Greenspan famously noted, sentiment can sometimes become “irrationally exuberant.”
Our large-cap, revenue-weighted index takes the same 500 companies in the S&P 500 Index but weights the companies on a quarterly basis of trailing 12-month revenue, or the income that a company receives from its normal business activities. The quarterly rebalance is designed to pull the portfolio away from companies with faster growing market capitalizations (price x shares outstanding) relative to the market, towards companies with larger revenue relative to other companies in the market. The result historically has been a higher quality, better valuation portfolio with smoother exposure to sectors and less concentration risk than the market-cap index.
A Revenue-Weighted Index Offers Better Performance
The upshot is that our large-cap, revenue-weighted index is currently trading at a price-to-sales of 0.80x, which is half that of the market-capitalization-weighted index. [Exhibit 2] Admittedly, the 0.8x price-to-sales is not necessarily cheap compared to the revenue-weighted index’s historical average, but is significantly less overvalued compared to history than is the market-cap strategy. The last time the S&P 500 Index’s price-to-sales breached the 1.9x price-to-sales threshold was in June 1998, on its way to a peak of 2.25x price-to-sales by the end of 1999. The advance in valuation was driven by a handful of stocks predominantly in the information technology sector, many of whom did not generate significant revenue. The systematic rebalance of the revenue-weighted index consistently allocated the index away from high-flying technology stocks in favor of companies generating sizeable revenue. Over the three-year period from June 30, 1998 to June 30, 2001, a period that included the final run-up in the massive technology rally and its ultimate demise, the S&P 500 revenue-weighted index outperformed the S&P 500 Index by 3.5% per year.
So the next time a strategist proclaims the S&P 500 Index to be overvalued, an obvious retort would be to ask which weighting methodology he or she is using. Because while a market-cap-weighted methodology might be producing overvalued exposure to equities, a revenue-weighted index might tell a completely different story.
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An investment in the Fund is subject to investment risk, including the possible loss of principal amount invested. Fund returns may not match the return of its respective index, known as non-correlation risk, due to operating expenses incurred by the Fund. The alternate weighting approach employed by the Fund (i.e., using revenues as a weighting measure), while designed to enhance potential returns, may not produce the desired results. Because the Fund is rebalanced quarterly, portfolio turnover may exceed 100%. The greater the portfolio turnover, the greater the transaction costs, which could have an adverse effect on Fund performance.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.