The S&P 500 Index Appears Inflated

The S&P 500 Index is overvalued compared to its long‐term history. Over the past 26 years, it has traded at an average price‐to‐sales ratio of 1.4, in contrast with today’s ratio of 1.95—a level it last reached in 1998, before climbing to 2.25.

Investors may be able to rationalize those valuations with today’s environment of low interest rates and inflation. Nonetheless, return expectations over the coming years should be muted and could undercut the justification for such high valuations.

What if there was a way to gain access to the broad market at significantly lower valuations and potentially enhance future returns?

Enter Revenue Weighting

We see nothing wrong with the holdings of the S&P 500 Index, but rather its weighting methodology. Our large‐cap revenue‐weighted strategy takes the same 500 companies in the index but weights the companies on a quarterly basis of trailing 12‐month revenue—the top‐line income that a company receives from its normal business activities.

Historically, this strategy has resulted in higher‐quality portfolios at more attractive valuations, with smoother exposure to sectors and less concentration risk than the market‐cap‐weighted index. Our large-cap revenue-weighted strategy (RWL) is currently trading at a price‐to‐sales ratio of 0.9, which is roughly half that of the market‐cap‐weighted index.

Diversifying Portfolios with Different Weighting Methodologies

We realize that switching to a revenue‐weighted S&P 500 Index may be a big shift for many investors who have been accustomed to the traditional index for six decades (even though we believe it is the right thing to do). But what if we split the ticket?

By allocating some of a portfolio’s market‐cap‐weighted exposure to a revenue‐weighted strategy, investors can target a price‐to‐sales ratio that is more in line with their risk tolerance, which may boost their odds of enhancing future returns. Case in point: A portfolio invested 50% in an investment vehicle tracking the market‐cap‐weighted S&P 500 Index and 50% in a revenue‐weighted S&P 500 strategy would be trading at a price‐to‐sales ratio of 1.4, which has been the average ratio of the index over the past 25 years. Perhaps our return expectations do not have to be so low after all.

Michael Jordan famously said, “All I knew is that I never wanted to be average.” Given today’s equity valuations, “average” would be a vast improvement.

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