Mining the Overvalued S&P 500 for Undervalued Gold Mines (Part 1)

Understanding the Market Through Earnings

To better understand the market’s valuation, we can analyze the S&P 500 using tools like FAST Graphs. When examining the index over the past two decades, one key takeaway emerges: the earnings of the S&P 500 have grown steadily, averaging roughly 8.5% growth annually over the past 20 years.

In valuation terms, the relationship between price and earnings is crucial. On a FAST Graph, the orange line represents earnings, while the black line represents stock price. When the price moves significantly above the earnings line, the market is considered overvalued. When price drops below it, the market may be undervalued.

Historically, a price-to-earnings (P/E) ratio of around 15 has been considered fair value for the market, while a P/E around 20 is often viewed as fully valued. Periods when the market trades significantly above these levels tend to lead to lower future returns.

For example, investors who purchased the S&P 500 during extremely high valuation periods have sometimes experienced years of very low returns—even when earnings continued to grow. Conversely, after the 2008–2009 financial crisis, the market traded well below fair value for several years. Investors who bought during those undervalued periods experienced strong long-term returns as valuations normalized.

Why the S&P 500 Can Be Misleading

Today, many investors look at the S&P 500 and conclude that the market is expensive. From an aggregate perspective, that observation has merit. But looking only at the index can hide an important reality: the S&P 500 is heavily concentrated.

The top 10 companies in the index make up roughly 35–45% of the total market value. Companies like Nvidia, Apple, Microsoft, Amazon, Alphabet, Meta, Broadcom, Tesla, and Berkshire Hathaway dominate the index. Because of their enormous market capitalizations, their valuations heavily influence the overall market.

When these companies trade at high valuations, they can make the entire index appear expensive—even if many other companies are reasonably valued or even undervalued.

This is why it’s important to remember that the S&P 500 may be an index of 500 companies, but its behavior is heavily driven by a small group of stocks.

Using Earnings Yield to Find Value

One useful way to evaluate valuation is by looking at earnings yield, which is the inverse of the P/E ratio. In simple terms, earnings yield measures how much earnings a company generates relative to its price.

As a general rule of thumb, a minimum earnings yield of about 6.5% to 7% is often considered attractive for value-oriented investors.

When examining the S&P 500 through this lens, a pattern emerges:

• Many of the largest technology stocks have earnings yields well below 4%, indicating elevated valuations.
• Some companies have yields even lower than 1%, reflecting extremely high price multiples.
• As you move further down the list of companies, you begin to find businesses with earnings yields approaching or exceeding 6.5%, which places them closer to fair value or even into undervalued territory.

This exercise quickly reveals something important: while the index as a whole may appear expensive, there are still many individual stocks trading at reasonable valuations.

Where the Opportunities Exist

When scanning through the S&P 500 constituents, numerous well-known companies begin to appear as valuations become more attractive. Firms in sectors like financials, healthcare, industrials, and consumer staples often trade at much lower multiples than the high-profile technology leaders.

Examples of companies that may fall closer to fair value or undervaluation at times include:

• Large banks such as JPMorgan or Wells Fargo
• Established technology firms like Adobe
• Consumer brands like General Mills
• Healthcare companies such as Biogen
• Telecommunications providers like Verizon

These companies may not dominate headlines the way high-growth tech stocks do, but many are high-quality businesses with stable earnings and solid long-term prospects.

The Key Lesson: It’s Always a Market of Stocks

The biggest takeaway for investors is simple but powerful:

Even when the overall market looks expensive, there are always opportunities to be found.

Bull markets, bear markets, overvalued markets, and undervalued markets all share one common characteristic—they contain both good investments and bad ones at the same time.

Investors who focus solely on broad market headlines may miss attractive opportunities hiding beneath the surface. By analyzing individual companies, studying their fundamentals, and applying sound valuation principles, investors can uncover strong long-term investments regardless of the broader market environment.

Valuation Still Matters

At the end of the day, investing success often comes down to a timeless principle: valuation matters—and it matters a lot.

Every investment ultimately derives its value from the cash flows or earnings it generates for shareholders. Wise investors estimate the value of those future earnings and determine whether the current price represents a reasonable purchase.

Markets will never ring a bell at the exact top or bottom. Perfect timing is impossible. But by consistently applying valuation discipline, investors can reduce risk while improving their long-term returns.

And that’s the real answer to the question, “How’s the market?”

The market may look expensive—but within it, there are always gold mines waiting to be discovered.

Disclosure: Long MSFT, TSLA, META, MMM, TGT, ES, JPM, DVA, AES

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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