Bank of America Defends S&P 500 Valuation at 35% Above Average

Bank of America Merrill Lynch (BofA) has asserted that the high valuation of the S&P 500 index is justified, given the current economic environment and the structural improvements in the index. Savita Subramanian, the bank's equity and quantitative strategy expert, argues that the index's high valuation is a feature of its high-quality, tech-heavy composition, rather than a flaw. She points out that the current index has higher quality, lower leverage, lower earnings volatility, and higher profit margins compared to its historical averages.

In a report released to clients on June 12, Subramanian noted that the S&P 500's forward price-to-earnings ratio stands at 21 times, approximately 35% higher than its historical average. She acknowledged that the index appears overvalued across all 20 valuation metrics tracked by BofA. However, she cautioned against relying solely on historical data, as it fails to account for the significant changes in the index's composition over time.

Subramanian highlighted that in 1980, nearly 70% of the S&P 500's constituents were capital-intensive manufacturing companies, whereas today that figure is less than 20%. She argued that comparing the index's valuation to its historical averages is akin to "comparing apples to oranges" and is meaningless.

Subramanian also defended the U.S. market's valuation premium over Europe and Asia, attributing it to the U.S.'s superior balance sheets, higher corporate transparency, and stronger long-term growth prospects. She pointed out that the U.S. has a leverage ratio half that of other global regions, lower earnings volatility than Europe, higher free cash flow per share than Asia and Europe, a lower proportion of unprofitable companies, and smaller earnings forecast dispersion, reflecting greater transparency.

Additionally, structural advantages such as the U.S. dollar's reserve currency status, energy independence, and technological leadership further justify the valuation gap, according to Subramanian. She believes that the valuation differential is unlikely to narrow significantly.

BofA's tactical model suggests that investors should focus on the communication services, utilities, and technology sectors in the U.S. The bank has identified interactive media and services, metals and mining, and independent power and renewable energy generation companies as the most "investment valuable" industries. Outside the U.S., Subramanian recommends a selective approach, favoring U.S. utilities over Asian counterparts, Asian communication services over European peers, and European non-essential consumer goods companies over their U.S. rivals.