Is the US stock bubble as big as early 2000? - Vivek Kaul's Diary
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Is the US stock bubble as big as early 2000?

Jun 6, 2017

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Pretty much everyone knows by now that US stocks are expensive. But one important measure shows the market is level pegging with the extreme end of the tech bubble. The S&P 500 index went on to fall by around half between 2000 and 2002 (whereas the NASDAQ Composite fell by four fifths). So what's this measure and what does it have to say about prospects for investors in US stocks?

Speculative bubbles are nothing new, nor likely to pass into history. Our technology changes but human weaknesses persist. Hubris, gullibility, greed, fear...all remain firmly on parade.

Perhaps counter intuitively, one of the best indicators of future stock market returns is the price-to-sales ratio (P/S). According to John Hussman at Hussman Funds there's a 90% inverse correlation between the historical levels of the S&P 500 index's P/S ratio (actually the logarithm of P/S) and subsequent investor profits over a 10 year period.

In other words, the higher the P/S the lower the future returns to investors are likely to be, with a high degree of linkage between the two measures. Which is a big problem, as I'll explain in a minute.

But first, why is the P/S ratio such a good measure in the first place? Surely there's a whole morass of unpredictables to wade through before we get to the residual figure that really matters: cash profits after tax. Surely it would make more sense to use some sort of cash flow or earnings based measure?

However, the reality is that, when plain old sales are used as the denominator that divides the valuation fraction, there's a surprisingly high (inverse) linkage to future investor profits. P/S beats P/E and even CAPE (Shiller P/E).

This is because profit margins also swing about. Sometimes they're high, sometimes they're low. Right now they're high, and the P/E is also high. Put another way, if profit margins today were more average, then the S&P 500's P/E of 25.7 would be even higher.

You can calculate historical net profit margins easily enough by dividing P/S by current (trailing) P/E and expressing it as a percentage. The result is E/S, which obviously enough is net margin (after tax, of course).

In December 2000 - after the bubble peak had already passed - this was 1.77 divided by 27.55 or 6.4% (using the earliest precise data I could find, from multpl.com). As of December 2016 it was 1.95 divided by 24.06, or 8.1%. If profit margins went back to 6.4%, but stocks prices didn't fall, the S&P 500's P/E would now be 30.5. Just saying...

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As high as the year 2000 bubble

But enough of P/E. Today's valuation multiple of interest is P/S and why it's a problem. And that is because the current P/S of the S&P 500 is 2.1.

Which is to say it's about the same level as it was in late 1999 / early 2000. You know, during maximum market euphoria. When any budding entrepreneur who could say the words "dot com" out loud would be showered with cash like a stripper at a convention of hedge fund managers.

Those dot coms were mostly over-hyped cash burners...and there's surely no shortage of those these days. They're just bigger now and have names like "Tesla", "Snapchat" or "Recently Listed Unicorn Inc."

All those hype stocks would have felt right at home during the South Sea Bubble, an earlier speculative episode in London from 1720. At that time, one company was described thus: "For carrying on an undertaking of great advantage, but no one to know what it is". The eager punters lapped it up, just as they do to this day.

It's worth remembering that no less than Sir Isaac Newton - who was not exactly a slouch in the brain department - lost a fortune during the South Sea Bubble. Many of his intellectual peers in the present day, even those that specialise in high finance, will find themselves in the same predicament from time to time.

So let's get back to the here and now, and the latest opportunity to lose a packet. The red line in the following chart shows the P/S ratio of the S&P 500 since 1993. You can clearly see it's right up there with the tech bubble peak.

S&P 500 price-to-sales since 1993 in red (Market Cap / GNP in blue)

Hussman's analysis says that means investors in the S&P 500 are likely to make a negative return over the next decade. That could average as much as minus 3% a year.

Assuming 2% a year inflation - the Federal Reserve's target - that's minus 5% a year real return. Which is to say a total real (after inflation) loss of 40% after ten years of compounding. That would certainly be a big hit to anyone's retirement fund.

[Incidentally the blue line shows market capitalisation in relation to the gross national product (GNP). This is another surprisingly reliable measure when it comes to assessing likely future profits, despite being theoretically flawed. And it's also scaling the heights.]

So far we know that P/S is currently at an extreme high that indicates poor long term investor profits. What's also interesting is that for practically the whole period in the chart, since 1993, it's been extremely high relative to the longer historical record.

According to some figures from Ned Davis Research, which go right back to 1955, before the mid '90s the previous peak of P/S was only 1.25. That was way back in the early '60s. And in the early '80s the market bottomed out right down at 0.35.

What happens if things go back to "average"?

From eyeballing part of Ned Davis's charts (too complicated to reproduce here) I'd say that the average P/S between the 1955 and 1993 was only around 0.7. That's a massive two thirds lower than today's level of 2.1.

Eyeballing the red line in the chart above suggests the average P/S since 1993 is about 1.5. Even if we're on a permanently higher plane of valuations for some reason (an argument for another day, but I have serious doubts), that average is still almost a third below the current market.

Would everyone be happy if the S&P 500 falls to 1,700 over the next couple of years, from its current 2,425? I doubt it.

Mind you, 1.5 was about the same P/S as the last market peak in 2007. The global financial crisis drove it down to below 1.0. I can't think of a special reason to suspect such a major meltdown of the financial system is just around the corner again (whereas I saw clear signs in early 2007). But how about a perfectly normal, common-or-garden, slow motion two year crash, perhaps with a little overshoot to the downside? It's not like there's a lack of things that could go wrong in the US or the world at large.

How about P/S gets to say 1.2 by mid 2019? That's over 40% below today, which would take the S&P 500 to around the 1,390 level.

Just because taxi drivers and grandmothers aren't asking for stock tips doesn't mean stocks aren't seriously overpriced or that the bull market can't end. This market's priced for perfection, which is another way of saying it's priced for disappointment.

The S&P 500's price-to-sales ratio has been one of the strongest predictors of long term returns in the past. At it's current level, as high as the peak of the 2000 bubble, it suggests a miserable decade ahead. And perhaps some seriously miserable years in between.

But all is not lost. There's usually opportunity to be found somewhere in the world. For some ideas on where to look now take a look at "Where to find growth AND value in today's markets".

Beyond that, my recommended asset allocations remain unchanged from those sent to OfWealth Briefing readers in September 2016 (and confirmed in November and December):

  • 40-60% in stocks, but only where prices are sensible
  • 30-40% in cash and bank deposits ("ammo" for future bargains)
  • 10-20% in physical gold (coins or allocated bullion)

Please note: This article was first published in OfWealth on June 2, 2017.

Rob Marstrand is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. He has spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time, he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. Later, he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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