Why the US equity market deserves to be trading at a higher earnings multiple

• In the years prior to the dotcom bubble, tech stocks accounted for less than 10% of the entire S&P 500 index. That number has risen to approximately 50% today. 

• As the global economy continues to shift towards digitalisation and innovation, Big Tech will play a crucial role in shaping the future of equity markets and the global economy.

• The US market has a rich history of innovation across a wide range of fields, from technology to healthcare. Its strong culture of entrepreneurship will help to ensure that it will remain as one of the most innovative places on earth for years to come.

• Besides producing much of the world’s innovation, the US has also been very successful in attracting innovators from across the world because of its well-developed capital market, proper infrastructure and abundance of market opportunities. 

• Considering the higher weighting of tech stocks in the S&P 500 and our positive outlook on the digital economy, we have decided to raise the fair PE multiple for the US from 18X to 22X.

• Using our revised fair PE multiple of 22X, we project an upside potential of 25% for the S&P 500 index, which translates to a target price of 6,820 (as of 21 June 2024). We have also upgraded the market from 2.5 Stars “Neutral” to 3 Stars “Attractive”.

The US equity market has grown by leaps and bounds since the beginning of the 21st century, riding on the wave of structural megatrends. But over the past few years, the rapid digitalisation of the global economy has really taken things to the next level. 

Just look at the largest publicly listed companies in the world today. Among the top 10, eight of them hail from the US. The two exceptions are Saudi Aramco (Saudi Arabia’s state-owned oil company) and TSMC (the world’s largest chipmaker). 

And among these eight companies, six of them are Big Tech firms (Table 1). The sheer dominance of these companies in equity markets underscores the pivotal role US tech companies play not just in the US, but in the global economy as well. 

Table 1: Six of the 10 largest companies in the world today are US Big Tech firms

Big Tech companies dominate the S&P 500 index today

Taking a deeper look at the composition of the S&P 500 index, we can see that it has evolved substantially over the past few decades. In the years prior to the dotcom bubble, tech stocks accounted for less than 10% of the entire S&P 500 index, while the biggest companies were mainly from the consumer, energy and industrial sectors.

Fast forward to today, the tech sector accounts for a staggering 32% of the S&P 500, displacing traditional sectors such as the ones mentioned above. But that is not all. If we include other large cap companies that are not officially classified as tech companies - such as Amazon, Meta, and Alphabet - the proportion of these companies rises to approximately 50% of the index (Figure 1).

Figure 1: The proportion of tech companies in the S&P 500 index has risen significantly over the years 

It is also worth noting that concentration within the S&P 500 has intensified, reflecting the dominance of these mega-cap tech companies. Traditionally, the 10 largest stocks used to make up between 15% to 25% of the index. However, this percentage has now risen to approximately 41%, with companies like Microsoft, Nvidia and Apple at the forefront. Naturally, with their increased representation, Big Tech stocks have not only become an important contributor to the index’s share price movements, but also to its earnings and valuations.

The emergence of Big Tech companies as a dominant force in the US and global equity markets reflects the longer-term megatrends in the economy towards digitalisation and innovation, and we believe that these companies will continue to drive market performance and shape the future of the global economy for many years to come.

America is the capital of innovation and home to many industry leaders

The US is the third most innovative country in the world trailing behind Switzerland and Sweden, at least according to the Global Innovation Index - which ranks 132 economies based on 80 factors spanning across areas such as education, infrastructure and the political environment (Figure 2).

Figure 2: The US is ranked as the third most innovative country in the world

Source: World Intellectual Property Organization
Data as of 2023

But in reality, it should be holding the number one spot. 

That is because the majority of global innovation comes from the US, even though the country makes up just 23% of global GDP. Look across the various sectors and there is a good chance you’ll find one or more US companies sitting at the top. Many of these companies also operate on a global scale, holding dominant positions not only in the US but also in various international markets. These industry leaders often possess competitive advantages such as network effects, while others operate in industries with extremely high barriers to entry (e.g. semiconductors). 

This is most evident in the tech sector where Big Tech firms dominate the entire, and often multiple industries. For instance, Meta and Alphabet combine to make up more than 50% of the global digital ad space, while more than 60% of the world’s cloud infrastructure is controlled by just three companies – Amazon, Microsoft, and Alphabet. The trio are also at the forefront of the development and commercialisation of AI technology. 

The dominance of US companies often extends beyond the realm of tech. In the pharmaceutical industry, four out of the top five companies (ranked by 2023 revenue) are US firms. Investors may also remember Pfizer, the company that developed the first Covid-19 vaccine (in collaboration with BioNTech). Today, Eli Lily is one of the leading pharma giants developing the highly popular weight loss drugs. 

SpaceX, a company founded by Elon Musk was the first to develop a commercially viable reusable rocket. No matter where we look, it is clear that the US has a rich history of producing innovation. Its strong culture of entrepreneurship will help to ensure that it will remain as one of the most innovative places on earth for years to come. 

But that is not all. 

Aside from producing innovation, it has also been very successful in attracting innovators from across the world to come to the US, thanks to its well-developed capital market. The US currently leads the world in venture capital investment, with companies receiving more than USD 80 billion already this year (Figure 3). Not surprisingly, nearly half that amount is concentrated in the Bay Area, where Silicon Valley happens to be.  

Figure 3: Majority of the world’s venture capital goes to firms in the US

A highly skilled workforce, proper infrastructure and an abundance of market opportunities are other factors that draw in foreign firms. The US also ranks highly in intellectual property protection, which can help companies to safeguard their competitive advantage. At the same time, it deters copying technologies while promoting R&D which ultimately raises the level of innovation in the country.

Such is the allure of the US market that foreign firms like Spotify and ARM have forsaken their home markets for a listing in the US. Back in 2014, even Alibaba (China’s largest e-commerce platform) chose to IPO in the US, driven by its desire to achieve a higher valuation and greater visibility for the company on the global stage.

US equities deserve to be trading at a higher multiple 

Given their high growth nature, tech companies tend to command higher valuations versus the broader market, and rightfully so because their stronger earnings growth. Between 2013 and 2023, earnings of US tech companies grew at a CAGR of 11.2% compared to just 7% for the broader of the market. Going forward, as more technology megatrends take hold, the sector is expected to deliver even stronger earnings growth of as much as 24% year-on-year, again leading the broader market. 

The higher weighting of tech stocks has a profound influence on the valuations of the S&P 500 index. Over the years, the average PE ratio of the S&P 500 over various five-year periods has increased, from roughly 13X back in 2009-2014 to nearly 21X today (Figure 4). This is no coincidence, and most likely driven by investors paying higher multiples for tech stocks.

Figure 4: Valuations of US equities have been rising over the years

Bearing this in mind, and our outlook for tech stocks to play a larger role in the US equity market, we have decided to raise the fair PE multiple for the US from 18X to 22X. We believe that 22X adequately captures the impact of the higher weighting of tech stocks in the S&P 500, as well as our positive outlook for the digital economy.  

Using our revised fair PE multiple of 22X, we derived a target price of 6,820 for the S&P 500 index, which translates to an upside potential of 25% (as of 21 Jun 2024). With this new upside potential, we have also decided to raise the star rating of this sector from 2.5 Stars “Neutral” to 3.0 Stars “Attractive”. 

Table 3: US equities have strong earnings growth potential, courtesy of the higher weighting of tech stocks

Figure 5: Share prices are driven by earnings in the long run

With its rich history and culture of innovation, we are confident that the US companies will be able to stay ahead of the competition and retain their position as industry leaders. Along with the country’s easy access to capital, economic stability and robust market infrastructure, the US market holds a significant appeal for investors seeking growth and new opportunities. Those who would like to invest in the US may consider the following products.

Table 3: Recommended products

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a NIL position in the abovementioned securities.