Dismissing the Case for CheapnessI realize that stock prices have come down quite a bit in the past few months. Many analysts, portfolio managers, financial journalists and strategists, not just the perma-bulls, contend the market is cheap. Their case rests on the assumptions of much higher normalized profits, low inflation and interest rates, and some kind of earnings discount model. But their case for cheap valuations clearly ignores historical absolute levels such as price-to-earnings, price-to-book value, price-to-dividends and price-to-sales ratios. Current P/E ratios are dismissed because of the recessionary earnings, book values are dismissed as obsolete, and dividends as irrelevant. Because of the perceived shortcomings in most traditional valuation measures, bullish investors can claim that shares are cheap without supporting statistical evidence. But let's take a look at the market's price-to-sales ratio, a valuation measure that's hard to dismiss.
|Lofty Levels |
The S&P 400 sports a relatively high price-to-sales ratio
|Sources: Marcin Asset Management, MSIM|
As you can see from this chart, the S&P 400 has traded around 140% of sales at bull market peaks and around 40% of sales at bear market troughs. That is, until the bubble of 1998-2000, the one that Greenspan could not identify. Then it traded up to 235% of sales, far surpassing any prior bull market level. Despite the vicious bear market of the past few years, the large-cap S&P 400 still trades north of 125% of sales. Over the past 75 years, this valuation level has been more closely associated with a bull market top rather than a bear market bottom. I would like to hear from the "Charlies" out there on how this parameter represents an undervalued stock market.