One of the industry’s metrics to determine valuation is the earnings yield. This figure, expressed as a percentage, reflects the return on investment based on current earnings and provides a comparison to other assets, such as bonds.

There is an extension to this valuation metric known as the earnings yield ‘gap’. Equities are inherently a riskier investment in comparison to bonds, therefore rational investors would expect to be paid a ‘risk premium’ to compensate for the additional risk taken on through equity ownership. This can often be measured as the ‘spread’ between earnings yield and risk-free rate of 10-year US Treasury Bonds:

The S&P500’s earnings yield “gap” has been approaching zero recently, due to long term bond yields increasing and from higher share prices. The narrowing of this gap signals that investors are paying a premium for stocks, relative to interest income alternatives. This supports the conclusion that the S&P 500, taken as a whole, is likely overvalued.

The unusually high concentration within the S&P500 index is another sign of a potential turning point in equity markets. The "Magnificent 7" companies (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) constitute over 26% of the index’s market capitalisation. This reflects an extreme level of concentration, rivalling past peaks seen before market corrections. For instance, similar patterns were evident before the Dotcom bubble burst in 2000 and during the lead-up to the 2008 financial crisis.

Historical precedents (see chart) show markets tend to correct when a handful of firms disproportionately drive overall gains, often due to unrealistic growth expectations or unsustainable valuations.

However, averages are misleading. When we break down the S&P 500, we find that high valuations in a small group of companies are distorting the overall picture. The forward P/E ratio for these seven companies currently stands at approximately 40. In contrast, the remaining 493 companies in the index are trading at a more reasonable average forward P/E ratio of ~17, which equates to an earnings yield of 5.9%. This significant valuation gap highlights that while the market as a whole might appear expensive, there are opportunities within the broader S&P493 that offer more attractive risk-adjusted returns. Many of these are expected to receive positive tailwinds from the implementation of “Trumponomics”.

Donald Trump's proposed policies, including his focus on reshoring manufacturing jobs and increasing industrial production, are expected to have a long lasting impact on the US economy. Raw materials, commodities producers and other industrial firms stand to gain from these policies, as rising tariffs and a push for domestic production could help bolster their profits by way of increased domestic investment. We have further outlined the implications of Trump’s proposed tariffs in our latest Chart of the Month. We believe that the companies and sectors within the S&P493 are more attractively valued and have more scope for earnings and price multiple growth.

While the broader S&P 500 index is showing signs of overvaluation, the S&P493 offers a compelling alternative. With more diversified exposure across industries and lower valuations, the S&P493 presents a balanced risk/return profile. Furthermore, considering the growth potential in sectors that stand to benefit from Trump's policies, such as steel and industrial production. By focusing on reasonably valued companies and sectors with strong fundamentals, we expect a better long-term return outcome in a market that is currently skewed by elevated valuations.