According to most valuation metrics, the S&P 500 and the C Fund that follows it is in its second most overvalued period ever, with the Dotcom Bubble of 2000 being the single most overvalued. In other words, stock prices are unusually high compared to their fundamental metrics like earnings per share.
This is true whether you measure S&P 500 valuation by the cyclically-adjusted price-to-earnings ratio, the market-capitalization-to-GDP ratio, the price-to-book-value ratio, the average dividend yield, or most other valuation metrics. They’re almost all at their second highest levels of the past century, with the sole exception of the Dotcom Bubble from nearly two decades ago.
But based on the price-to-sales ratio of the S&P 500, stocks are even more expensive now than in 2000. This metric has reached new record heights in 2017 and 2018:
Source: multpl.com
During previous market tops like in 2007 and even 2000, the price-to-sales ratio of the S&P 500 never reached even 2x. But now it stands at over 2.3x.
Back in 2013, the price-to-sales ratio was only 1.3x. Just five years later, investors are now paying about 75% higher stock prices for each dollar of annual sales.
Some analysts argue that since sales are harder for corporations to manipulate than net income, the price-to-sales metric is closer to the “true” valuation of the market than other valuation metrics.
In contrast, other analysts grant that the market is highly valued, but point out that S&P 500 average profit margins have increased from 7% in 2000 to 10% today, meaning that paying a higher price-to-sales multiple is fair. The shift of the S&P 500 towards high-margin tech stocks is playing a role.
Asset Allocation
Either way, we’ve had a tremendous increase in valuations over the past several years alone. If the S&P 500 were to return to being at a 2x price-to-sales ratio (still more highly valued than any previous market top), it would represent a 14% stock price decline from today’s level. And if the S&P 500 were to return to being at a 1.5x price-to-sales ratio (where it was at just a few years ago), it would represent a 35% stock price decline. This is something to be aware of when determining your overall asset allocation strategy today.
That being said, although current valuations do affect long-term stock market rates of return, they can’t tell us almost anything about 1-year returns. As the following charts show, there is virtually no correlation between current valuation (price-to-earnings in this case) and 1-year returns, but there is considerable correlation between current valuation and 5-year returns:
Source: J.P. Morgan 2018 Q1 Guide to the Markets
Even stronger correlation exists between current valuations and 10-year returns, or when you use more sophisticated valuation techniques, like the cyclically-adjusted price-to-earnings ratio rather than just the raw price-to-earnings ratio.
Lifecycle Funds
At this stage in the market cycle, it’s important not to take for granted the stock gains you’ve hopefully enjoyed up to this point. Check your current asset balance to ensure that you are appropriately diversified for your financial goals. Lifecycle funds are a great option for many folks because they continually rebalance themselves back to their target allocations.
Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.