If the market drawdown persists, mega-cap stocks could lose more "froth" and pressure equity valuations more broadly, Charles Schwab Chief Investment Strategist Liz Ann Sonders suggested this week.
Chaotic trade and tariff policy and the "massive re-rating in the mega-cap world" are key factors in the market slide, along with previously stretched valuations that saw many metrics reach or nearly achieve all-time highs, she said Monday in a report co-authored with Kevin Gordon, Schwab senior investment analyst.
The strategists, noting the drop in mega-cap price-to-earnings valuations, wrote, "As a group, the Mag7 — which lately can be thought of as the Lag7 — has seen its forward P/E contract sharply in the most recent selloff. ... At last year's peak the forward P/E jumped close to 33. As of last Friday's close, it sat just above 24."
The group has gone through more severe drawdowns, notably in 2022, Sonders and Gordon noted. So while the current pullback hasn't yet dealt a major hit to the rest of of the market's valuation, if the drawdown is more protracted, "there is likely more froth to be wrung out of the mega caps. Unfortunately, given their weight in the cap-weighted indexes, any continued weakness would put disproportionate pressure on the market."
The report noted that the tech-heavy Nasdaq index's forward P/E has dropped to 24, its lowest since early 2023.
Broadly, trade policy "has limited businesses' abilities to make capital spending and hiring plans, and helped drive the market into a correction, exacerbated by stretched valuations," the pair wrote.
"In the midst of a market correction — especially given the deteriorating inflation and forward earnings backdrop — a look a valuations is instructive ," Sonders and Gordon wrote. "Price declines, all else equal, ease valuation excesses. But the current environment has the 'double rubs' of stagflation concerns and accelerating corporate (and consumer) angst, which is putting downward pressure on future assumptions about growth and earnings. Valuation is an indicator of sentiment, and sentiment is not set to improve until there is more government policy-related clarity."
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