Not since the days of Alan Greenspan, has the economy been so petrified of the news cycle. In his 19 years as Fed chairman, economists and investment analysts a like, would pour over FOMC meeting minutes trying to ascertain the meaning of words like “expect” or “anticipate”. Now, all it takes is a twitter handle. That twitter handle, and the person behind it, have been the root cause of frequent market drops and rebounds. If we really stop and think about why investors are so quick to sell, I bet we could figure it out with minimal effort. In my humble opinion, it seems that investors are overly optimistic. When a single sign of trouble appears, investors get out of dodge fast.
From May’s market open until Monday May 13th, the Dow has lost approximately 800 points. In the last month of trading, it’s over 1000 points. This has become a very frequent trend in the market. Over the last few years, as seen below, there has been many examples of market excitement and market panic. For all the bullish investors out there, if the market is so strong why does one tweet cause such a sell off? The answer is simple. Major investors know that the market has grown over valued and are quick to sell with any sign of uncertainty. I contend that we are drastically overvalued, which is why there are drastic and frequent sell offs (chart below courtesy of Yahoo Finance). I intend to lay out my evidence to show this.
There are several methods to determine if a stock is worth buying. One ratio that is considered the least likely for a company to manipulate is the price to sales ratio. This ratio “is calculated by taking a company’s market capitalization … and dividing it by the company’s total sales or revenue over the past 12 months” (Investopedia). This essentially takes the market cap, which is the number of shares times share price, 12 months of income and gives you a ratio of sales to stock price. This ratio describes the value the market places on each dollar of revenue earned. I decided to dig into the ratio and see how it piece changed over time. In this short sample size, you can see that over the last 10 years, revenue has grown at a consistent 5-6% (redline below). However, the market capitalization has grown 3 times as much. Where does that leave us?
To drive these points further home, since 2000 the price to sales ratio has climbed to approximately 2.125%. This means that for every $1 that was earned in revenue, the market cap (which is essentially the stock price) has increased by $2. I hope this helps clarify my stance on over valuation. In the chart below you can see that we have reached the highest price to sales ratio, which includes the tech bubble and the great recession of 2008.
I submit to the jury my final piece of evidence regarding the market overvaluation. This is the Schiller PE ratio. To be honest, I was less familiar with this ratio that I would like to admit. The typical PE ratio, which stands for price to earnings, is used “… for valuing a company that measures its current share price relative to its per-share earnings (EPS)”. This ratio has become one of the most widely used ratios for valuation. However, any number of creative accounting methods can cause a misleading PE ratio. In contrast, the Schiller PE ratio is the “cyclically-adjusted price-to-earnings ratio, popularized by Yale professor Robert Shiller. This metric divides the current price by the inflation-adjusted average of the past ten years’ worth of earnings” (Investopedia).
In the chart above, (Graph courtesy of Multpl.com) the Shiller ratio maps out over the last 100 + years, the highs and lows of this ratio. If’s you are like me, you probably start to see some familiar points on this graph. The 2 larger dots symbolize the 1999 tech bubble and the 2008 housing crash. The current 29.75 is floating around the same high as the 2008 housing crash and Black Tuesday, which presided the Great recession. Not exactly a comforting thought, to be aligned with the ominous dates.
My final thought is this; we have been in a bull market for over 10 years. And yet it seems that we are still not learning out lessons. With investment professionals on TV and news saying the market is strong and pushing aggressive investment philosophies, we are only getting one side of the story. As Warren Buffet said regarding investing, “… Be fearful when others are greedy. Be greedy when others are fearful.” Since investors are chomping at the bit to jump into bull market, perhaps it might be time to take a step back before the bull market runs you over.
Works Cited
https://www.multpl.com/shiller-pe
https://seekingalpha.com/article/4165371-price-sales-valuation-tool
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