Nvidia, the chip maker of the AI revolution, has played a starring role in the market's climb to record highs. But even its shares aren't commanding the premium they once did.
Since January, the stock's valuation multiple, or the price that investors are willing to pay for each dollar of a company's earnings, has dropped significantly. It isn't alone; the S&P 500 has seen its multiple slide even as the broad index has rumbled to new highs.
Wall Street blames rising rates.
The 10-year Treasury yield, which touched a new 24-year high on Wednesday, just posted its steepest quarterly increase since 1994. Aside from the chilling effect higher borrowing costs have on debt-dependent industries such as real estate, a higher 'risk-free rate' impacts how Wall Street values riskier assets. The enthusiasm for investing in an asset riskier than government debt wanes as yields rise, and stock prices tend to drop unless earnings expectations are growing enough to make up for it.
"The rise in interest rates has already had a huge impact on the stock market," said Bob Doll, chief investment officer at Crossmark Global Investments. "P/E ratios have fallen three turns. The impact is very direct, but hidden because earnings have been so phenomenal."
Since the S&P 500's previous closing high on Aug. 13, 18 of the 25 S&P 500 industry groups have dropped. Meanwhile, an equal-weighted version of the benchmark is down 5%. Several industries, including banks and real estate, have slid more than 10%.
The index's latest rally has relied on its largest subsets -- software, technology and semiconductors. All three are bound together by investors' unbridled enthusiasm for AI, and earnings projections that seem to grow by the day.
The S&P 500 is now trading at roughly 19.3 times its constituents' projected earnings over the next 12 months, down from 22.2 times at the beginning of the year. Valuations have dropped sharply since Treasury yields began to climb off the year's low, which came the day before the U.S. launched strikes on Iran.
Stellar corporate earnings and forecasts for next year have helped stocks tread water even though valuations have dropped.
"If I told you at the beginning of the year, 'We're going 100 basis points higher on the 10-year,' there's no way you would have landed on the outcome that we've had," said Alex Chaloff, chief investment officer at Bernstein Private Wealth Management. "But the reality is earnings have been fabulous."
They will have to be even more fabulous for the market to keep going up.
As the third quarter reporting season kicks into full swing next week with reports from JPMorgan Chase, Citigroup and other Wall Street heavyweights, the bar investors need companies to clear has gone higher.
"This is kind of finance 101," said Mark Hackett, chief market strategist at Nationwide Investment Management. "Higher interest rates make stocks less valuable."
On Wednesday, the S&P 500 and Nasdaq composite slipped from records, while the 10-year Treasury yield was volatile, surging above 5.36% before settling at 5.276% after an auction of new 10-year notes met with strong demand.
The market's heavy concentration in just a handful of multitrillion tech companies -- a theme throughout the current bull market -- has become even more extreme as stocks in other industries took a hit in recent months.
Microsoft, Nvidia, Apple and Meta Platforms alone contributed around 300 points to the S&P 500 during the third quarter, or more than three times the index's gain, while the other 496 companies collectively detracted 150 points, according to research from Citadel Securities.
Concentration is near all-time highs by several metrics. While that leaves the market vulnerable to a downturn in those companies, it is another reason why the index has withstood a chilling effect from higher rates.
"The stock market is not the economy, and increasingly, the S&P 500 is not the average stock," Citadel's Scott Rubner wrote to clients.
The Dow Jones Industrial Average, often viewed as a barometer for the economy, is down 4.2% in the past month, compared with a nearly 4% gain for the Nasdaq. Shares of Goldman Sachs, Boeing, Home Depot, Nike and McDonald's have all weighed on the index.
At Crossmark, Doll expects higher rates will continue to be a headwind for equity markets, especially for cyclical companies that are sensitive to the economy.
"If you have a little cash, that's OK because I don't think stocks are going straight up as they basically did until the past few months," he said.
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