The S&P 500‘s performance over the last three years has been truly remarkable. Since December 2022, the US flagship stock market index has delivered a total return just shy of 75%. That’s the equivalent of a 20.5% annualised growth rate – more than double its long-term historical average of 10%!
However, while that’s fantastic news for anyone who’s been buying shares, fears are on the rise that the gravy train may soon come to an end. After all, the US economy’s currently riddled with uncertainty. And it seems that only aggressive AI spending is the reason why GDP continues to grow.
But is this fear overblown?
Is the S&P 500 overvalued?
There are lots of different metrics investors can look at to try and gauge where we stand in the current market cycle. But one of the most popular is looking at the price-to-earnings (P/E) ratio of market indices.
Looking at the S&P 500, the index currently has a P/E ratio of around 30.8. For reference, the long-term average for US stocks is closer to 19.4, which means that if the market were to suddenly return to the average, investors could be hit with a painful 37% downward correction.
But these figures are somewhat misleading. The S&P 500’s weighted based on market capitalisation. That means the largest companies like those in the Magnificent Seven have far more influence over the trajectory of the index versus smaller players. And with more capital being concentrated into these tech giants, the index as a whole has been lifted to lofty levels.
Yet on an equal-weighted basis, the S&P 500’s P/E ratio drops to just 22.5. That’s still above the historical average, but far less extreme.
This suggests if a correction does come along, most of the risk exposure is concentrated into just a small collection of the 500 companies in the index. And that creates some interesting opportunities for stock pickers.
Buying opportunities to consider
One business that’s caught my eye recently is Adobe (NASDAQ:ADBE). The creator of Photoshop and other creative tools has had a rough ride, slipping by over 37% in the last 12 months, while other tech stocks have continued to rally. And as a result, its shares are trading at a relatively undemanding P/E of 20.1.
With new AI tools cropping up, the level of competition for this business has increased significantly. And analysts are growing concerned that it could soon face pressure on its software subscription pricing plans.
However, Adobe has nonetheless been launching its own AI tools to counter this threat. And as a highly cash generative business, the firm’s gross and operating profit margins remain enormous at 89% and 36% respectively.
With so much excess earnings at hand and its share price falling, management’s been buying back its own stock. In fact, the number of shares outstanding has dropped by almost 10% since August 2024 – a pretty rare sight in the tech sector, where stock-based compensation dilutes shareholders rather than supports them.
That’s why, despite the seemingly overstretched valuation of the S&P 500 index as a whole, I think it might be wise to take a closer look at Adobe shares. And it’s not the only undervalued growth opportunity I’ve got my eye on right now.
