According to Michael Lebowitz at 720 Global, this idea holds especially true when you examine the valuation of companies’ stocks to how much they’re actually selling, also called the price-to-sales ratio (P/S ratio).
“At its current record level, the P/S ratio leads us to one of two conclusions: 1) Investors are extremely optimistic about future economic and earnings growth or 2) Investors are once again caught up in the frenzy of an equity bubble and willing to invest at valuations well above the norm,” said a note from Lebowitz, an investment consultant and macro research firm, on Tuesday.
“Either way, the sustainability or extension of the current P/S ratio to even higher levels would be remarkable.”
Currently, according to the note, the S&P 500’s P/S ratio is “now 2.50 standard deviations from the median” and roughly equal to the level just before the bear markets of 2000 to 2002 and 2007 to 2008.
There are two important things to understand in order to get why this elevated P/S ratio will cause troubles, said 720.
One, as revenue expectations rise, so too should stock prices. An investors will pay more for a company that is expected to grow revenues by 10% than one that is only going to grow revenue by 2%.
“Purchasing a mutual fund, ETF or an equity security is essentially buying a claim on a potential future stream of earnings cash flows,” wrote Lebowitz.
“The odds, therefore, of a rewarding investment are substantially increased when a company, or index for that matter, offering substantial market growth potential is purchased at a lower than average P/S ratio. Value investors actively seek such situations. Logically one would correctly deduce that P/S ratios should tend to follow a similar directional path as expected revenues.”
Additionally, sales and earnings follow incredibly closely with GDP growth. So expected sales increases should track along the same path as expected economic growth, according to 720. With economic growth projected at around 2% as far as the eye can see, revenue growth should also follow those muted expectations.
Given those two factors, the current lofty P/S ratio for the S&P 500 is either a reflection that investors are seriously encouraged by the possibility of strong revenue growth above the current trend, or they are stuck in a bubble fervor fuelled by a lack of other places to invest.
“Perhaps the lack of viable options for investors to generate acceptable returns, has them reluctantly ignoring the risks they must assume in those efforts,” said Lebowitz’s analysis.
“If that is indeed the case, then one should also consider the possibility that the next correction will extract more than a pound of flesh in damage.”