Price to Sales

For the last six years we’ve had one of the biggest bull markets in history aligned with one of the weakest recoveries in history. The economy is improving though. Income growth for corporate America is projected to be 9% through the end of 2016 according to Bloomberg. That growth however, is already priced into the market with the S&P 500 increasing in price almost 5X faster than the GDP. That’s the highest ratio since 1947. The increased growth rate is both good news and bad news for investors. In a market fueled by low interest rates and increased debt; any sign that the economy is recovering too fast means the Fed may increase interest rates which could lead to a bit of market havoc.

While the Fed remains dovish they have changed their language recently. While saying they forecast low rates for a considerable time, they also inserted an escape clause should the economy improve faster than expected.

“If incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated,” says the Fed statement. “Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.”

The grand Fed experiment of all-time continues. So far it has been an overall success, with certain economic subsets benefiting a great deal more than others. However, the lengthening timeline has also introduced an extra element of uncertainty and risk. Alan Greenspan, the former Fed chairman has commented that he thought it was impossible for the Fed to exit from easy monetary policy without market turmoil. When and where market turmoil will rear its ugly head, remains to be seen. Are you prepared?

Last month I covered the short comings of using the P/E ratio in isolation to gauge whether the market (or a stock for that matter) was overvalued or undervalued historically on a P/E basis. This month we’ll concentrate on the Price-to-Sales ratio (P/S). The Price-to-Sales ratio is the stock’s price divided by earnings per share. This is considered a purer valuation ratio compared to the P/E ratio because it cannot be manipulated as easily by accounting and financial structures.

The current average P/S ratio of the stock market stands at over 10.5. To put that in perspective, in March of 2000 the average P/S was 13.7 at the height of the dot com bubble and 9.9 prior to the stock market crash in 2008.

The high P/S valuation is to be expected somewhat because the P/S ratio does not take into account the profitability of those earnings. Profit margins for companies continue to be on the high-side which justifies an elevated P/S. But how high?

I would suggest that the market has gotten ahead of itself.