Executive Summary
In this week’s missive, I will focus on one financial metric to demonstrate the absurdity of today’s stock market prices. One of the best valuation methodologies is the price-to-sales ratio (P/S). It can be said that this metric is better than price-to-earnings because of the ability for corporations to manipulate earnings. The average price-to-sales ratio for the S&P 500 is around 1.75. As shown in the graph below, the current P/S ratio is 2.92 or 67% above the mean. A better comparison than the average would be the median. The long-term median P/S ratio is about 1.55. The current P/S ratio is about 88% above the median and the median is 47% below current levels. Although the above valuations seem a bit ridiculous, I have not even gotten to the absurd part. Nvidia, representing 7% of the S&P 500, maintains a P/S ratio of 38. Even if Nvidia’s sales growth rate were seven times higher than the average company, would that justify a P/S ratio 21 times higher than the S&P 500 average?
Please continue to The Details below for the potential outcome from this absurdity.
“Every absurdity has a champion to defend it.”
–Oliver Goldsmith
The Details
In this week’s missive, I will focus on one financial metric to demonstrate the absurdity of today’s stock market prices. I will keep this newsletter brief to avoid detracting from the simple point I am attempting to convey. One of the best valuation methodologies is the price-to-sales ratio (P/S). It can be said that this metric is better than price-to-earnings because of the ability for corporations to manipulate earnings. Through accruals, estimates, reserves, etc., companies can force certain effects on earnings in the short run. Also, Wall Street tends to favor “adjusted” earnings versus GAAP (Generally Accepted Accounting Principles) earnings, because they tend to give credence to higher valuations. P/S ratios avoid much of this manipulation.
The average price-to-sales ratio for the S&P 500 is around 1.75. As shown in the graph below, the current P/S ratio is 2.92. Therefore, looking strictly at the long-term average P/S ratio, the S&P 500 would need to fall around 40% just to get back to the mean. However, notice in the graph that the P/S ratio has trended higher since the Fed began its interventions, through Quantitative Easing (QE) and extreme interest rate policies, along with unprecedented stimulus from the Federal Government.
A better comparison than the average would be the median. The long-term median P/S ratio for the S&P 500 is about 1.55, or 47% below current levels. And it is not uncommon for the P/S ratio to fall below the median during different stages of the business cycle. A drop in the ratio below the median could entail a fall in the S&P 500 of over 50%.
Although the above valuations seem a bit ridiculous, I have not even gotten to the absurd part. The S&P 500 is a market-cap weighted index. The larger the company the more weight in the index. On an equal-weighted basis, each company would represent about 0.2% of the index. One company, Nvidia, currently represents almost 7% of the S&P 500. Nvidia is a rapidly growing technology company, that with its software and graphics processing units represents the “engine” behind AI (artificial intelligence). And while their unique position in the industry should warrant some level of boost in their valuation, the present level of their stock price is nothing short of absurd.
The graph below illustrates the P/S ratio for Nvidia. The current ratio is 38. Eventually Nvidia’s sales growth rate will slow with market saturation and competition. Even if the sales growth rate were seven times higher than the average company, would that justify a P/S ratio 21 times higher than the S&P 500 average?
Because of its market cap, the action of speculators in Nvidia stock has produced large daily swings in stock market indices. Some speculators continue to revert to the growing use of 0DTE, or zero days to expiration options to bet on hourly movements in stocks and indices. 0DTE speculation now comprises almost 50% of daily market volume for the S&P 500. The absurdity of the absurd.
As explained in last week’s newsletter, it appears the blow-off speculation phase of the market could be coming to an end. The amount of air between current prices and those considered “reasonable” could involve a market drop of 50-70% by the end of the cycle, as shown by economist Dr. John Hussman last week. While speculators could try to extend the period of gambling a little longer, investors should be aware of the extreme risk priced into today’s stock market.
The S&P 500 Index closed at 5,460, down 0.1% for the week. The yield on the 10-year Treasury
Note rose to 4.34 %. Oil prices increased to $82 per barrel, and the national average price of gasoline according to AAA rose to $3.49 per gallon.
© 2023. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.
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