Executive Summary

  1. If we’re going to use valuation metrics to make important financial planning and investment decisions why wouldn’t we use the most reliable metrics at our disposal?
  2. The Price/Sales ratio has a much higher correlation to actual subsequent returns than Price/Earnings.
  3. Price/Sales, and other reliable metrics, indicate the U.S. stock market is more expensive than it’s ever been in history.

Relationship to Actual Subsequent Returns

We use valuation metrics to determine if the stock market is cheap or expensive. Since we’re potentially making decisions based on that assessment it should be obvious that we’d want to use the most reliable metrics available.

“Reliability” is measured by a metric’s correlation with actual subsequent returns.

Therefore, I’m astounded that so many investment professionals, pundits and economists often focus on the price-to-earnings ratio (Price/Earnings or P/E) when there are more reliable metrics available.

Specifically, the correlation of Price/Earnings (trailing 12-month earnings) to actual subsequent 10-year stock market returns is -0.76 while the correlation of Price/Sales (P/S) to actual subsequent 10-year returns is -0.89! Even the correlation of price/forward earnings is only -0.78.

– Credit to Dr. John Hussman for the correlation data.

If we have a choice between using P/E or P/S why wouldn’t we use P/S?

I don’t blame retail investors for focusing on P/E’s because it’s not their job to know better and nobody has shared this information with them (perhaps because many professionals themselves aren’t even aware of this data). Hence, my reason for writing this commentary. However, there is no excuse for professionals to continue relying on P/E for their assessments when there are obviously better, more reliable alternatives.

Why is P/S Better More Reliable?

P/E seems like an appropriate metric to use since a stock’s price should be a reflection of long-term earnings. After all, it’s not how much you sell but how much you keep that matters, right? So, why is P/S so much more reliable for forecasting actual returns?

Well, the answer is not actually that complicated. Earnings are a function of profit margins and sales, and profit margins are mean-reverting (see chart below).

The reason why P/E is so much less reliable than P/S is because P/E assumes margins will remain at current levels forever, whether margins are low or high at that moment in time.

Currently, corporate profit margins are very high. Long-term average margins are around 8% while current margins are about 12%. It’s not reasonable or realistic to assume margins will be sustained at 12% long-term.

Meanwhile, margins aren’t included at all in the P/S ratio as its simply price of the market divided by sales.

If we want to use P/E to assess market valuation and forecast returns then you have to make an adjustment for margins. When we make that adjustment correlations increase and the adjusted P/E metric becomes more useful.

Additionally, earnings can be more easily manipulated than sales.

Is the Market Cheap Or Expensive?

Now that we know P/S is a more reliable metric let’s look at P/S data to determine if the market appears cheap or expensive.

Below is a chart showing Price to Sales for the S&P 500 since 1990.

h/t @Callum_Thomas

We notice on this chart that the S&P 500 price is about 3x sales while it peaked recently at over 3.2x in late-December before the stock market started declining this year.

P/S is higher than it’s been since at least 1990 exceeding even the dot-com bubble peak of about 2.4x. From that high watermark of the Dot-Com Bubble the S&P 500 essentially went nowhere for ten years.

The low P/S of the period was 0.65x on 1/9/1991. The S&P 500 increased by over 300% (not including dividends) from that point over the subsequent ten years.

By the end of the Great Financial Crisis, P/S was about 0.7x and we know the subsequent ten years from that point was also a very strong period for U.S. stocks.

This all goes back to a point I’ve made many times before: The price you pay determines your return.

Let’s look at P/S another way.

The chart below shows the percentage of stocks within the S&P 500 trading at over 10x sales.

We observe that there are more than twice the number of companies trading at over 10x sales today than there was even at the height of the Dot-Com Bubble when tech stocks were trading based off clicks and eyeballs as opposed to actual revenue, earnings and cash flows.

h/t @LizAnnSonders

P/S is obviously indicating the market is very expensive at least in the context of the last 30+ years.

The challenge with P/S is it’s hard to find data going back very far. However, in other commentaries I have previously written about even more reliable metrics with data going back to the 1940s and even the late-1920s that all indicate the same conclusion: The U.S. stock market is more expensive than it’s ever been in at least 100 years.

As I’ve emphasized in the past, high valuations don’t tell us anything about short-term returns as those are not predictable at all. But high valuations do imply that returns for U.S. stocks over the next decade are likely to be quite low or even negative.

Therefore, risk management is critical, using lower-than-average return assumptions within financial plans is important to avoid poor financial decisions, and diversifying away from U.S. stocks and incorporating assets that have traditionally performed well when stocks performed poorly may be a life-saver for many investors.

Note: No valuation metrics are reliable indicators for short-term returns. Even the most reliable are only reliable for subsequent 10-12 year returns. 

Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.

Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices
including factors not mentioned here.

This is not investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.

Views provided here are current only as of the moment of posting and are subject to change at any time without notification.

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