Valuations Are Slipping Even as Stocks Hover Near Records

Wall Street Journal / Michael Wursthorn

Stock-market valuations are lower now than they have been for a while, but that doesn’t mean shares are cheap.

Despite another robust corporate earnings season, the S&P 500 has inched up less than 1.5% over the past three weeks as simmering trade tensions and signs of slowing growth at big technology companies sapped investor confidence. Those issues have helped drive valuations down near their lowest levels of the year, even with the broad stock-market index hovering just 0.7% shy of its January high.

The S&P 500 trades at 18.8 times earnings over the past 12 months, a basement valuation that is lower than the market’s February trough, when the index’s valuation was around 19 times earnings, according to FactSet. At the S&P 500’s peak in January, the index traded at nearly 22 times earnings.

Strong corporate earnings are making stocks look less pricey than they did before. Companies in the S&P 500 have posted double-digit profit growth for the past three quarters to help earnings catch up with the S&P 500’s 6.7% advance this year. For the latest quarter, profits are on track to register a rise of 25% from a year earlier, one of the fastest rates of earnings growth since 2010, according to FactSet.

But by other measures, stocks still look expensive: The S&P 500 is currently trading in the 88th percentile of historical valuation, Goldman Sachs said in a recent report, while the median stock is at the 97th percentile.

Stock prices are steep, in part, because of the surge in shares of technology companies. The popular corner of the market, which has been a big contributor to the run-up in major indexes over the past several years, continues to command big multiples that worry some investors.

“Valuations have gotten more extreme in the last three to five years,” said Mike Balkin, a portfolio manager at William Blair. “The FANG stocks have looked especially expensive, but if you didn’t own them, your performance suffered,” he said, referring to the crowded trade of Facebook Inc., Inc., Netflix Inc. and Google parent Alphabet Inc.

Tech companies in the S&P 500 are trading at 21 times their earnings over the past 12 months, well above the broader index and most other sectors. That is partly because investors have sought safety among shares of technology companies, which have contributed to much of the long-running rally, at any sign of trouble in the market this year.

But some analysts warn that higher-valuation stocks tend to struggle over the long term. An analysis of price/earnings ratios found that stocks with richer valuations led to weaker returns over a 10-year stretch, according to Credit Suisse Group AG .

Wall Street’s infatuation with technology stocks briefly stalled last month after Facebook and Netflix reported financial results below investors’ expectations. Those stocks have stumbled 11% and 17%, respectively, over the past month and trimmed valuations of S&P 500 tech companies slightly.

Investors are questioning whether those companies and others in the tech sector can continue their heady growth paths unabated. New regulations in Europe and the prospect for tougher oversight in the U.S. have dented performance. Facebook, for example, said its European user base took a hit after a tough new European privacy law went into effect in the second quarter.

“Investors are now asking how long can growth stocks really continue to outperform,” said Matt Forester, chief investment officer at BNY Mellon’s Lockwood Advisors. “It’s reasonable to question whether some of those expectations had been too high.”

Some money managers are using the weakness among tech companies to urge clients to trim tech-heavy portfolios and put that money into the market’s cheaper corners. Wells Fargo Investment Institute, for example, cut its view of tech stocks to “neutral” for the second half of the year and is favoring shares of financial companies. Inflows into tech-focused funds have slowed this year, so much so that some funds, such as the iShares U.S. Technology exchange-traded fund has lost $350 million this year, according to FactSet.

Some investors have been plowing that money into other assets, such as short-term government bonds, whose yields have jumped to their widest margin against the S&P 500’s dividend yield in years, while others have opted for more-defensive footing among equities, such as shares of financial firms, utilities and health-care companies, where valuations are more attractive.

The shifting landscape has led to a rare break in leadership for tech stocks. The health-care and the financial sectors of the S&P 500, corners of the market that had been out of favor, are outpacing the tech sector’s 6% gain so far this quarter, while industrial stocks aren’t far off.

Facebook’s earnings spooked investors enough to “begin shifting assets to the more value-oriented areas” of the market, said Robert Pavlik, a senior portfolio manager at SlateStone Wealth, in a recent note to investors. “We believe this is just the beginning foray into these groups.”