What factors explain the robust performance of the S&P 500 over the past year?
Although the drivers of short-term performance are varied, long-term stock market performance can overwhelmingly be chalked up to two primary drivers: earnings growth and dividends. Dividends have generally been a steady source of return, while earnings growth has provided the primary underpinning for the positive performance of the stock market over longer periods, as illustrated above.
A third factor tends to have a comparatively limited effect on returns over the long term but can be a considerable contributor over shorter periods. Seldom has that been more apparent in recent years than over the 12-month period ended March 31. Earnings growth was in the high single-digits over the past year, roughly in line with its 30-year average. What drove the strong return of the S&P 500 over the last 12 month? A sharp increase in the S&P 500’s valuation multiple (measured by the price/earnings or P/E ratio) accounted for almost two-thirds of the index’s gain of nearly 30% over that period.
A marked increase in the P/E multiple is often associated with an improvement in investor sentiment. As recession fears subsided, inflation receded, and the Fed announced a pause in rate hikes, a more optimistic investor mood emerged over the past year, lifting equity prices but also pushing equity valuations higher. The emerging artificial intelligence theme was a key driver as well, creating a strong tailwind for a handful of stocks that led the market through 2023.
What’s the bottom line? Earnings and dividends both positively contributed to the S&P 500’s return over the past year, but a marked improvement in investor sentiment — evidenced by a sizable expansion in the market’s P/E multiple — was a considerable driver of the return for the index.
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