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Looking for Froth in S&P 500 Sector Weightings

No single sector in the S&P 500 has raced ahead of the others, but that's not necessarily comforting.

With the S&P 500 Index recently crossing 2,000 en route to new record-highs, more investors are looking for evidence of an equity bubble. But, as many have pointed out, this push into record territory is unlike past surges in that it hasn't been driven exclusively by any one sector. This is in contrast to when technology stocks led the way during the dot-com bubble of the late 1990s and when financials played a prominent role in the rally prior to the late-2007 onset of the credit crisis. There hasn't been a consistent face of this bull market. Sectors have cycled in and out of favor, with the relative constant being the market’s march higher.

This balance shows in the S&P 500's current sector weightings. When a particular sector outperforms the others, it grows as a percentage of the index and at the expense of its counterparts. But no one sector today is even 20% of the index. Tech stocks come closest, with 19.3% of the index. But this figure is far below the level of 14 years ago when tech claimed 32.6% of the index. Tech stocks have performed particularly well over the past year, gaining about 32% on average, but over the past five years both consumer discretionary/cyclical and health-care stocks have fared slightly better.

Speaking of health care, even with its strong five-year returns (20% annualized on average), that sector’s weighting is also below its high. While never on par with tech or financials as a share of the index, that group did claim 15.5% of the index in March 2003 versus 13.4% currently.

Financials have never dominated the index the way tech stocks did during the dot-com bubble, but their influence was clear when they became a record 22.4% of the index in September 2006. Consider that financials were just 6.5% of the S&P 500 in late 1994 following the S&L crisis and Fed rate hikes. From the market's peak in 2000 through September 2007, financials roughly doubled the S&P 500's annualized return.

Energy stocks were the other main driver of the 2003-07 rebound. After tanking with oil prices in the late 1990s, energy stocks roared back as oil prices boomed in the first half of the 2000s. Energy stocks fell to just 3% of the S&P 500 in November 1999--while tech stocks boomed--when oil was around $20 per barrel. From then until June 2008 when energy stocks peaked at 16.2% of the index, energy stocks gained an annualized 16.6% (as measured by the  Energy Select Sector SPDR ETF (XLE)) versus 0.6% for the S&P 500 overall. Energy stocks have since retrenched and are now a fairly modest 10.6% of the index.

Valuations Look Uniform, Too
When it comes to valuations, no single sector seems particularly expensive relative to the others based on Morningstar equity analysts' measures of price/fair value for companies under coverage. Still, if one had to choose a potential culprit, tech might be the natural choice. At 1.10, tech has the richest price/fair value estimate of the major sectors. Plus, as mentioned above, that sector also has the largest weighting within the index.

On the other hand, the sector has traded at loftier valuations during the past five years. The tech companies in Morningstar's coverage universe reached an average price/fair value of 1.24 in January 2011, and early this year they were at an average price/fair value of 1.17. Of course, this isn't to say that tech stocks, or those in other sectors, can't fall from here. And based on their average price/fair value ratio, tech stocks certainly don't look cheap. 

None of the other major sectors look cheap either based on estimated price/fair value ratios. In fact, no sector has an estimated price/fair value below 0.99, which is right at fair value. This relationship even holds when looking at estimated values for the different moat categories. Wide-, narrow-, and no-moat stocks currently trade at estimated price/fair ratios of 1.01, 1.03, and 1.04, respectively. Meanwhile, Morningstar's entire coverage universe has an average estimated price/fair value of 1.03, which equates to slightly overvalued.

With no obvious areas of froth, the next correction or bear market may be distributed across sectors rather than hitting one or two especially hard. This isn't a prediction; where we go from here is anyone’s guess. But unlike during the dot-com bust in particular, diversification across sectors--or, more to the point, underweighting a particular sector--may provide less protection next time around.

Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.