As you can see from the image at the top of this email, the S&P 500 currently has the highest Price to Sales Ratio in history at 3.15. This is up from 1.77 in Q4 of 2000 when the Nasdaq was in the midst of crashing by 80% peak to trough. Now on the positive side, the dominant businesses today are much more profitable than they were in 2000, justifying a higher multiple than in the past, but we are truly at stratospheric levels, so the risks are ratcheted up. We also are at a major inflection point between growth and value stocks as you can see in the second image. Growth stocks are the most expensive relative to value that they have ever been, even surpassing what we saw in 2000, which many people thought would never happen.
This is important because mean reversion is a very important force in equity markets. For periods of time, excesses can develop in either direction and they can last quite a long time. However, over the long-term, valuations tend to mean revert, which is what we saw in from 2000-2007 when growth stocks got crushed, but value performed exceptionally well. We saw a similar dynamic in 2022 during that bear market.
According to Bank of America Securities research, the index is “statistically expensive” on 19 of 20 valuation metrics compared with historical averages. Companies have been beating on earnings and profit margins have held up even with higher interest rates and tariffs. It’s a really interesting dynamic and there are no easy answers. As usual in my opinion, the best strategy is to take a very businesslike approach to you investing. You want to know what you own and why you own it. For instance, if you are buying Nvidia, what are your earnings projections in two years to justify that valuation? Tactically, we must pay a lot of attention to what is appropriate based on our individual circumstances. If you are retired and are relying on your investments to fund that retirement, is it appropriate to own 100% or even 80% stocks, at the highest valuations in history? Probably not. The good news for investors is that there are a lot of good alternatives to just owning the index. Many real estate stocks and bond funds have yields between 6 and 11%, with upside beyond that. Those might be easier and less risky hurdles to jump over, and I think it is very likely they will outperform the S&P 500 over the next decade. Because so much money has flowed into AI, we can acquire high and growing cash flow yields for very low prices, as they are simply not in favor currently. As we can mean reversion play out, I expect to see very strong returns for value stocks from these extremely oversold levels.
