If you’ve noticed stock market “winners” and “losers” more lately, it’s because the gap between valuation multiples among U.S. companies is now the widest on record since the peak of the Tech Bubble in the 2000s, according to Goldman Sachs.
Even within sectors, the “collective top 20% of stocks from every S&P 500 sector trade at a median [second fiscal year] multiple of 27x, while the bottom 20% of stocks with the same sector composition trade at a multiple of 9x,” Goldman Sachs said in note. That makes the gap within sectors the widest in 20 years, the firm said.
As the coronavirus has propelled certain stocks far above the pack, investors are seeing heady new valuations for some of the standouts. Of note, coronavirus staples Netflix and Amazon both posted recent highs in late April. But at those prices, shares in Netflix and Amazon have gotten expensive. Amazon is currently trading around 114 times trailing earnings, while Netflix comes at a pricey 89 times trailing earnings.
“Diving beneath the surface, although the S&P 500 as a whole remains down ‘only’ [12%] for the year, many stocks are still down over 70%, while other stocks have already surpassed their all-time highs, reflecting investors’ attempts to pick out the winners from the losers within this awful health crisis,” Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, wrote in a recent note.
Why is the valuation gap so wide right now?
For those like Sameer Samana, Wells Fargo Investment Institute’s senior global market strategist, the reason for the gap is pretty clear: Amid all the uncertainty, investors are willing to pay up for what they perceive has more certainty.
Samana suggests investors have been eyeing trends that were in place before the coronavirus that have been “turbo-charged” amid containment measures, like online streaming, work from home technologies, and food delivery—and are betting on those trends sticking around post-COVID.
“I think that’s what’s creating the valuation gap—more and more people are treating those companies as almost these perma-growth type of sectors and industries,” Samana tells Fortune.
Yet while many of these top performers in the coronavirus stock market are perceived to benefit from further growth even when quarantines end, Goldman notes that “differences in long-term growth expectations explained the valuation gap between the haves and have-nots in 2000, but don’t explain the gap in valuations today.” Historically, stocks with high expected growth typically trade at higher multiples than peers, the firm notes. In 2000, Goldman says the gap in “inflated” long-term growth expectations was especially large, contributing to the contrast in low and high valuations. Today, that distribution of growth expectations isn’t too far above average now, but low interest rates have made equity valuations particularly sensitive to long-term growth estimates, only bolstering the gap in valuations we’re seeing.
In fact, Samana points out that comparing companies’ valuations based solely on P/E ratios (and not taking growth rates into account) is like “apples and oranges” right now (“how can you compare utilities to tech?”).
Instead, Goldman suggests that current valuation dispersion is “more closely tied to actual profitability”—The median return on equity for the highest valuation stocks in the S&P 500 right now is 23%, versus 13% for the lowest valuation stocks (the largest gap on record), the firm says. (Plus, Goldman points out companies considered “high quality,” with strong balance sheets and high profit margins, are also trading at premiums versus “lower quality” names.)
Analysts, however, don’t think the yawning gulf between the most and least expensive stocks will last forever. “You never quite know how far the valuation gap will go before it reverses. We all appreciate reversion to the mean, … but you never quite know when that reversion will start,” says Samana.
Closing the gap
Unlike during the Tech Bubble—which saw many expensive names “catch down,” the firms says—Goldman now estimates that “the extreme current valuation gap between the most expensive and least expensive stocks will most likely be closed when an improving economic environment causes the low valuation stocks to ‘catch up’ to the current market leaders.” That’s based on the pattern that, historically, low valuation stocks were able to find their footing and outperform a rallying market once the economic tide has turned.
With that in mind, for investors focused on more relative returns, the potential for a “catch up” of cheaper stocks should prompt them reexamine (and potentially add) positions in low valuation stocks—provided they have long time horizons and a strong stomach for dips in the meantime, analysts at Goldman write.
However, the firm notes that while the extreme gap in valuations could limit the absolute upside of more expensive stocks moving forward, they will “likely outperform in a weak market by declining less than peers, but nonetheless post positive absolute returns in the event of a rally.”
Wells Fargo’s Samana is of the same mind: He says there will come a time when it makes sense to rotate out of the high-flying stocks and “toward these more cyclical areas that are more beat up and trading a little bit more cheaply.”
But, he adds, he doesn’t think we’re quite there yet.
More must-read finance coverage from Fortune:
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—Real unemployment rate soars past 24.9%—and the U.S. has now lost 33.5 million jobs
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—Does Apple’s stock buyback strategy make sense in this market?
—Goldman Sachs doubts there will be a Round 3 of PPP loans for small businesses
—Listen to Leadership Next, a Fortune podcast examining the evolving role of CEO
—WATCH: Why the banks were ready for the financial impact of coronavirus
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