The S&P 500 has rallied 20 per cent in the past year but it’s cheaper than it was 12 months ago, because earnings have grown even more than that, writes Mark Lister. Photo / NZME

There’s lots of nervousness about sharemarket valuations at the moment.

That’s understandable, especially regarding the United States market, which has more than tripled in value since the end of 2018.

Including dividends, the S&P 500 index has returned 14.5% so far this year, well ahead of the long-term average ofabout 10%.

In the seven years before this one, the market has posted four 25%-plus annual gains, and another two where it was up almost 20%.

The lone decline was an 18% fall in 2022, which is now long forgotten given all the fantastic years surrounding it.

Part of the reason for this great run is the resilience of the US economy in recent years.

Aside from the brief (but harsh) 2020 recession, which was engineered, America hasn’t suffered a recession since the GFC in 2008 and 2009.

It’s weathered the storm of rising inflation and interest rates, tariffs and now the oil shock remarkably well, which has been reflected in the sharemarket.

The S&P 500 has also been propelled by the emergence of AI into the mainstream.

ChatGPT burst onto the scene in late 2022, helping lift US shares out of the funk they were experiencing at the time.

Since then, a raft of new and existing businesses across the broader technology sector have produced some returns that are nothing short of astounding.

That doesn’t mean those stocks are all overvalued, nor does it suggest the market is due for a fall.

Earnings have more than kept pace with share prices, and for the most part the rally has been driven by fundamentals, rather than speculation.

The S&P 500 has rallied 20% in the past year, but it’s cheaper than it was 12 months ago, because earnings have grown even more.

Aggregate earnings for the S&P 500 rose 32% in the June quarter, relative to the same period a year earlier.

That was the second consecutive quarter of annual earnings growth above 25%, and the seventh consecutive quarter of double-digit growth.

When share investors think about valuations, they’re not focused simply on the current share price compared to the old price.

They also think carefully about what you get for each dollar you put in, in terms of the underlying earnings, profits and dividends.

Right now, the price/earnings (P/E) ratio for the S&P 500 is 20.6, above the 10-year average of 19.5 but not dramatically so.

It’s also lower than the 22.8 that prevailed a year ago, which makes the S&P 500 about 10% cheaper today (relative to its earnings, at least).

However, if we look back to 1990, the average P/E is about 17, which starts to make today’s level of 20 look a bit more overdone.

However, the obvious counter to that argument is to consider the types of businesses that make up the index today.

The potential earning power of Nvidia, Apple and Microsoft is impressive enough to command a higher P/E.

In 1995, the three biggest stocks were General Electric, AT&T and ExxonMobil, so the comparison is not apples for apples, is it?

Then again, some market strategists believe the bubble is in earnings, rather than share prices.

They argue that huge AI spending is creating unusually high revenues and margins for some businesses, flattering those P/E multiples.

As capacity catches up with demand, we won’t face the same shortages and pricing power could fade, impacting earnings even if the technology itself is transformative.

I don’t know which of those scenarios (if either) will eventuate, so I’d hedge my bets.

It’s not wise to sit fearfully on the sidelines during a period of solid economic growth and strong earnings momentum.

If I can’t hear recessionary alarm bells ringing, I’m inclined to stay invested and stick to my strategy.

You don’t want to be all in on the tech and AI trade either, mind you.

That’s why many astute investors are ensuring they’re also exposed to other parts of the market, and the world.

Some of the less exciting sectors are more modestly valued with less enthusiasm priced in, while some regions are less susceptible to a potential AI stumble than others.

Valuations are elevated, but they’re certainly not alarming, especially when the exceptional earnings growth of recent quarters is considered.

That doesn’t mean markets aren’t facing risks, though, and it might ultimately come down to the sustainability of those earnings.

Mark Lister is investment director at Craigs Investment Partners. The information in this article is provided for information only, is intended to be general in nature, and does not take into account your financial situation, objectives, goals, or risk tolerance. Before making any investment decision, Craigs Investment Partners recommends you contact an investment adviser.