Another Look at Equity Valuations: How Expensive is the Market Right Now?
Few market topics are currently as contentious as the U.S. stock market outlook. The bulls will admit that recent U.S. economic growth has been subpar, but they still see the next recession as distant. The bears generally fall into the fundamentalist camp. Using various metrics, they see the stock market today as expensive, and many view the market to be prone to a collapse similar to the 2000-2003 and 2007-2009 bear markets.
The outlook for returns on government bonds is predictable. Look at the yield today and the duration of the portfolio and you have a good return forecast for that horizon. Equities are much more uncertain as future revenue, earnings, payouts, etc. all have variable elements. As we set the outlook for equity returns, we use several metrics and valuation models in an attempt to build a mosaic that will reveal a general trend.
Price to Revenue is a valuation metric we at Segal Marco think is useful in forming the outlook for equity returns. While not having the same economics as earnings (the old joke about a business with a negative profit margin making up for it on volume), revenue is also less subject to company and auditor manipulation. It’s purer. So let’s look at historical Price to Revenue based on aggregate values.
Source: Segal Marco Advisors Risk Management Group and Bloomberg
On an aggregate basis, the S&P 500 began the ‘90s with a Price to Revenue ratio of 0.74. But when dot-com mania kicked into high gear in the late ’90s, Price to Revenue ratio on the index surged to triple that value at 2.25. At its late ‘90s peak, 45% of the S&P market cap was concentrated in 25 companies, many of which were in the technology sector.
As the dot-com bubble burst, the Price to Revenue ratio retreated, stabilizing around 1.5 or double the initial ratio. As the housing bubble collapse and fear of a repeat of the great depression grew, prices declined substantially into late 2008, bringing the ratio back to the level of the early '90s.
Since the start of the recovery, we have witnessed a dramatic recovery in the ratio. Other than two brief consolidations, the ratio has been a straight line higher. However, as of late July 2017, the ratio has not surpassed its 1999 blow-off peak.
As mentioned earlier, the previous ratio was based on aggregating each company’s market cap and revenue and developing a composite ratio. The problem with this is that a few highly valued companies can skew the metric. By digging into the individual companies and looking at the median ratio, we can get a better flavor of the market in general.
Source: Segal Marco Advisors Risk Management Group and FACTSET
Using the median company ratio, a very different story is revealed:
- The dot-com bubble was concentrated in a few issues, as the median Price to Sales ratio was significantly less than the aggregate.
- The first bear market did much to clean-out the concentrated over valuation as both metrics were similar going into the housing bubble.
- Both metrics bottomed at similar levels, as the Global Financial Crisis (GFC) was systemic.
- Today, the median company’s Price to Revenue ratio has significantly exceeded both the dot-com and housing bubble highs and is in fact higher than the aggregate market.
It’s clear from the chart and table below that stocks are universally richly priced today. While the FAANG stocks get a lot of headline exposure, the typical stock today in terms of trailing revenue, is at an all-time high valuation.
But we’re not ready to predict a market correction/repricing. That’s because this current market looks different than that of other recent frothy markets. In the late ‘90s, there were many viable alternatives to the grossly overpriced equity market:
- Value stocks or an equal weighted equity index
- TIPS were an outstanding value with a real yield of over 4% (virtually unheard of in 2017)
- Real estate sported attractive cap rates
- Even cash looked attractive
Heading into the housing bubble of the mid to late 2000s, the opportunity set was more modest than the turn-of the century but value could still be found.
Today is a different story as exemplified with the acronym TINA (There Is No Alternative). Segal Marco feels that the return outlook for U.S. equities is lower relative to history given the median Price to Revenue among other variables. However, the risk premium (or relative return) has not diminished substantially. See the below table for various asset class metrics.
Central banks have responded to the GFC with a massive liquidity dump through ZIRP, NIRP and QE (zero interest rate policy, negative interest rate policy, and quantitative easing). The much maligned wealth effect has played out, as financial asset values have been inflated.
Unless the central banks are able to unwind their monetary stimulus programs in a controlled, transparent, and systematic fashion we are unconvinced a market crash is unlikely. Rather, it exists, but only in the tails of the probability curve. We continue to talk to clients about diversifying, the use of multi-asset class strategies and other effective ways to give portfolios downside protection.
- On an aggregate basis, the S&P 500’s Price to Revenue ratio has not exceeded the highs reached in the late ‘90s dot-com bubble.
- However, the median company’s ratio has made substantial new highs during the recent post Presidential election market rally.
- While not driven by the concentrated euphoria of the late ‘90s, today’s market expensiveness is widespread and pervasive. Today, unlike the dot-com bubble, alternative asset classes are also expensive.
- Overall, the largest contributor to the high valuations is central bank policy.
- Our outlook for intermediate returns is more modest than historically but absent a mistake by the central banks, a stock market crash is relegated to the tails of the distribution.