On May 21, 2015, the Ss&P 500 Index closed at a record high. Since the March 2009 lows, the index has appreciated by over 210% on a price basis and, as a result, the price-to-earnings (P/E) ratio has expanded from 11x to 18.8x1. Now, six years into this bull market, many market participants are concerned about both the price appreciation and multiple expansion, actively debating whether the markets are ripe for a pullback.
If you are also concerned about valuations, then we think you should look to fundamentally weighted investment options, which tend to be more sensitive to valuations. WisdomTree feels that weighting by market capitalization , which does not weight, consider or rebalance back to any fundamental value, renders an investment most susceptible to bubbles. We believe that a disciplined strategy of anchoring allocations back to a concept of relative value, based on fundamentals such as dividends or earnings, can protect against valuation risks.
The Fundamental Difference
The WisdomTree Earnings 500 Index (WTEPS) seeks to provide exposure to the 500 largest profitable U.S. companies but to do so while maintaining sensitivity to valuation. To help achieve this, the Index weights companies by the profits they generate, rather than their market cap, and rebalances back to profitability on an annual basis.
WisdomTree’s rebalance process typically is driven by:
• Earnings Growth: Companies increasing profits see their weight increased
• Relative Performance:
P/E Ratio Weight Distribution
The annual Index rebalance process tends to shift weight to firms with the lowest P/E ratios and away from firms with the highest P/E ratios. The chart below helps visualize the distribution of stocks by their P/E ratios for the WisdomTree Earnings 500 Fund (EPS), which seeks to track WTEPS before fees and expenses, against the S&P 500 Index, one of the most widely followed market cap-weighted indexes.