One of my favorite valuation measures in the stock market is the price-to-sales ratio. It measures the market value of a company, sector or entire index to a level of sales or revenue. Measuring price against sales is helpful because revenue is much more stable than income statement residuals such as earnings. Also, from sales come all the income-statement goodies like profits and cash flows.


frequently use price-to-sales ratios to identify undervalued companies or sectors in the stock market. But I also use it to pass judgment on the valuation of the overall level of the market as represented by a comprehensive market index like the large-cap S&P Industrial 400. Right now, this parameter suggests the current price level of the index has limited upside. It also calls into question the consensus earnings estimate for 2004.

Inside the Numbers

The index, which includes all companies in the

S&P 500

except the financials and the utilities, trades around 1200. The current P/S ratio is around 150% and the sales level for the index is $800 a share. Taken in isolation, this valuation level is much more characteristic of a bull market peak rather than an under- or fair-valuation level. In fact, only the bubble of 1999-2000 generated higher levels over the past 75 years. No other bull market in history eclipsed the 150% level. Bear markets have bottomed between 35% and 60% of revenue in that same time period.

Studying the market's P/S ratio also reveals interesting information about profit expectations embedded in current valuations. The ratio is a function of the index's after-tax profit margin multiplied by its price-to-earnings ratio. If the index trades for 150% of revenue and the P/E ratio is 20, the earnings levels implies a 7.5% after-tax margin on sales. These numbers are relatively consistent with 2004 forecasts for the S&P 400.

S&P Industrial 400
Investors are chasing momentum stocks and could be in for a huge letdown

Index sales -- at $800 a share -- have declined since the economy peaked in 2000 due to poor revenue growth and share dilution. Even if they resume some modest growth level for next year, few expect nominal revenue growth of more than midsingle digits. A 6% growth rate would generate around $850 in 2004 sales. To hit the earnings estimate of $62 a share for the index, margins would have to be 7.3% after tax. These margins would be higher than the 2000 peak of 6.8% and significantly higher than the past 10-year average of 5.3%. Not only is the market discounting a strong economic recovery in 2004, but one of the largest annual increases in corporate profitability as well.

Ignoring Valuation

What does this all mean? Well, at around 19 times 2004 profits, the S&P 400 is hardly cheap. But even this high P/E ratio assumes strong revenue growth and peak profit margins for the index. I think those estimates are so aggressive as to be unachievable; but even if the index did achieve them, would you want to pay peak multiples for peak margins? I don't think so.

Yet that's what "professional" investors are doing in this rally. Ignoring sensible valuation guidelines, they are chasing performance with expensive momentum stocks. Since investors paid high P/E ratios for depressed profits, should they not discount peak margins? Of course they should! Just don't expect any Wall Street strategists to enlighten them to this margin issue.

Lately, many of the bulls have become even more emboldened with predictions of big upward moves yet ahead. On


, I've seen more than a few predict another significant leg up through 2004. The problem with that is valuation. Except for the bubble, that 150% P/S ratio has been a cap over many decades. A meaningful move in stocks greater than their midsingle-digit growth necessitates an expansion of the P/S ratio back to bubble levels.

Could the


produce a sequel to the "New Era?" Well, it's certainly

trying every trick in the book. But I don't think a followup to the original mania, or a "Double Bubble Trouble," would be in the best interest of investors or corporations. My guess is the market is now more susceptible to bad news or an external shock than it has been in quite a while.

The market is trading up big to high valuations on a modest economic bounce and big helping of momentum. If the mo goes, there are hordes of investors waiting to sell the break. Too many investors learned that from the vicious bear of 2000-2002.

If Greenspan and his cronies continue to spike the punch bowl and the music stays hot, the party might continue for a spell. This year might represent this market's version of the annual rally that accompanied the secular bears of the 1930s in the U.S. and the 1990s in Japan. I

mentioned this as a possibility in January.

But it doesn't represent the start of a new secular bull market. Simple math supports that contention; math that is perhaps too obvious, or maybe too ominous, for your typical Wall Street talking head to heed.

Robert Marcin is the principal of Marcin Asset Management, a private investment firm. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). At the time of publication, Marcin had no holdings relative to this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to