Is the U.S. Stock Market Overvalued?

• Author: McKinsey
• Position: OFF THE NEWS

The S&P 500 is a value-weighted index, meaning that each company's contribution to the index is not equal, but a reflection of its individual value. While in most years unusually high- or low-value companies will cancel out any distortion to the index overall, that isn't always the case. In 1999, for example, a small number of mega-capitalization (megacap) stocks with very high price-earnings ratios distorted the index. Removing those companies led to a PE ratio for the rest of the index that was well within normal bands. Something similar happened decades earlier. In 1972, a high-market-capitalization company like Kodak traded at 37 times its forward earnings and Xerox traded at 39 times.

"We find the same situation today. Four megacap companies--Amazon, Facebook, Google (Alphabet), and Microsoft--together valued at more than $2 trillion, account for 10 percent of the index and, as a group, trade at a PE ratio of 29. Excess cash among the remainder accounts for...