On November 18, 2017, Denver, CO-based asset management company Crescat Capital sent a letter to all of its clients discussing how the stock market is currently more overvalued than it has ever been in history. While I would recommend that anyone with interest in the capital markets (presumably everyone reading this) to review the 25-page letter, I will attempt to summarize it and add my own thoughts in this article. My very long-term readers may recognize some of the points presented here as I have pointed them out over the past few years in various earlier articles.
In the letter, Crescat Capital shows conclusively that US large-cap stocks are the most overvalued in history, even more so than during prior manic market peaks in 1929 and 2000. The firm does this using six metrics:
- Enterprise Value-to-Sales
- Enterprise Value-to-EBITDA
- Enterprise Value-to-Free Cash Flow
These six metrics, some of which are ignored by many professional investors, provide a very comprehensive valuation of companies. When we consider that all six of these metrics are stating that US large cap stocks are overvalued, we should certainly be willing to consider the very present risks that exist before putting any further money into these stocks. There are of course many pundits that will seek to provide a justification for today's stock prices but consider the following excerpt from Crescat Capital's letter:
"Brutal bear markets and recessions have historically followed from record valuations like we have today, and this time will almost certainly be no different. Not even positive macro factors like low interest rates, low inflation, or recently improving earnings growth can justify today's extreme valuation levels. As we show herein, that was the same backdrop that we had in 1929, the setup to the biggest market crash in history and the Great Depression. Optimism over 'new-era' technologies are not justification for high multiples today; they are hallmarks of market tops. Artificial intelligence and crypto-currencies feature prominently in current investor enthusiasm, a climate akin to the tech bubble peak. Also, excitement over new pro-business and pro-economic growth policies coming from Washington are poor grounds to rationalize today's valuations. Again, this is a hallmark of a market top. History has proven that market plunges typically follow first-year Republican presidents where ebullience over business-friendly government policy runs rampant and only sets the market up for failure. Witness the market meltdowns that followed Hoover (1929), Eisenhower (1953), Nixon (1969), Reagan (1981), and Bush (2001) in their first years. Any real economic boost from Republican tax cuts now before Congress, if such legislation passes, is already more than priced into the market."
Crescat Capital appears to be predicting a sharp market correction within the next few months. While I am certainly hesitant to predict that, the market is indeed highly overvalued as we will see shortly. This does present a situation where the risks of capital losses due to a market correction are higher than the possible gains by staying long.
The price-to-sales ratio is a commonly used financial ratio that compares a company's stock price to its revenues per share. Investopedia has a more indepth definition:
"The price-to-sales ratio is a valuation ratio that compares a company's stock price to its revenues. The price-to-sales ratio is an indicator of the value placed on each dollar of a company's sales or revenues. It can be calculated either by dividing the company's market capitalization by its total sales over a 12-month period, or on a per-share basis by dividing the stock price by sales per share for a 12-month period. Like all ratios, the price-to-sales ratio is most relevant when used to compare companies in the same sector. A low ratio may indicate possible undervaluation, while a ratio that is significantly above the average may suggest overvaluation."
Here is how the media price-to-sales ratio of all the companies in the S&P 500 Index has varied over the past 23 years:
As we can see here, the median price-to-sales ratio is currently substantially higher than at any other time since 1994, a period of time that includes the excessive valuations of the technology bubble. There are two possible conclusions here. The first is that the market expects large-cap companies to grow their revenues at a more rapid pace than ever before. The second is that the market is greatly overvaluing stocks based on their current trailing revenues. The second seems much more likely to me. However, the price-to-sales ratio is not the only way to value a stock, nor is it the best way in my view.
Another way to value stocks is a metric known as the price-to-book ratio. The book value of a company is the accounting value of a company's tangible assets minus its liabilities. It is thus theoretically the amount of money someone would receive if they were to buy the company and liquidate it. As usual, Investopedia has a better definition:
"Book value of an asset is the value at which the asset is carried on a balance sheet and calculated by taking the cost of an asset minus the accumulated depreciation. Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities. For the initial outlay of an investment, book value may be net or gross of expenses such as trading costs, sales taxes, service charges, and so on."
The price-to-book ratio is thus a measurement of how much money an investor will have to pay to get $1 of book value in a company. Here is the median price-to-book ratio of all the companies in the S&P 500 Index over the same 23-year period:
Personally, with the possible exception of insurance companies and banks, I do not consider the price-to-book ratio to be a very good metric to use to value a company. This is because how much a company paid for an asset rarely has any relevance to how much it is earning (and many times fully depreciated assets can still generate profit) and oftentimes the value of an assets on a company's books is very different from what it might get if it attempted to sell the asset. Nevertheless, as the chart clearly shows, the price-to-book value of the median company in the S&P 500 Index is currently at higher levels than at any time since 1994.
There are two primary ways used to determine the total value of a company. The first of these is market capitalization (or market cap), which is the value most often shown at financial websites and in news and analyst reports. However, a far better measurement is the enterprise value. The enterprise value is the figure most often used by investment bankers, private equity analysts, and others that would be analyzing potential merger and acquisition activity. Investopedia defines enterprise value thusly:
"The Enterprise Value, or EV for short, is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. Enterprise value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents."
The enterprise value is used by dealmakers because it is effectively the total amount that it would cost to outright buy the entire company (the reason that cash and cash equivalents are excluded is because this money will come back to the acquiring company after deal consummation).
Enterprise values marketwide have been growing quite rapidly in recent years because American large-cap companies have been taking on copious amounts of debt. Today, the total amount of debt relative to assets in the S&P 500 is at all-time highs.
In addition, and perhaps even more consuming, US corporate debt relative to US GDP is currently at its highest level ever. Please note that this chart is for the entire US economy, not just the S&P 500 Index.
These two factors alone should be concerning for investors. This is due to the risks involved with leverage - namely the need to make regular payments on the debt. In the case of corporate debt, companies typically only have to make interest payments until the debt matures, at which point the company will need to either pay off the debt with cash on hand or, more commonly, roll over the debt. In today's low interest rate environment, it could certainly be argued that these payments are unlikely to be a problem for most profitable companies.
However, most economists are predicting that interest rates will rise going forward. So, what happens when the time comes to roll over these loans (as few companies will be able to cover them solely with cash on hand)? The company will be forced to roll them over at a much higher interest rate, which will have an adverse effect on the company's cash flows and some companies may not be able to afford the higher payments. This is basically the same problem that occurred a decade ago with subprime mortgages.
There are a few valuation rates that use enterprise value and these also point to company valuations being absurdly high. One of these ratios is the enterprise value-to-sales ratio. As can be expected, this ratio tells us how a company's enterprise value compares to its sales. Here is Investopedia's definition:
"Enterprise-value-to-sales is a valuation measure that compares the enterprise value (EV) of a company to the company's sales. EV-to-sales gives investors a quantifiable metric of how much it costs to purchase the company's sales. This measure is an expansion of the price-to-sales (P/S) valuation, which uses market capitalization instead of enterprise value."
Here is how the enterprise value-to-sales ratio has varied over the past 23 years for the median company in the S&P 500:
As can be clearly seen here, it is substantially more expensive for investors to buy $1 of sales than it has been at any time in the past 23 years. As I mentioned earlier however, I consider sales to be less important than profit when determining whether a company is appropriately valued.
As my regular readers likely know, one of my favorite metrics to use is the enterprise value-to-EBITDA ratio. EBITDA is occasionally used by investment bankers as a proxy for free cash flow, but the two are rarely the same. What EBITDA does do well is provide a capital structure- and regime-neutral view of a company's earnings.
In combination with the also capital structure-independent enterprise value, the EV/EBITDA ratio provides a far better valuation metric than the much more commonly used price-to-earnings ratio (discussed shortly). Here is how the EV/EBITDA ratio has varied for the median S&P 500 company over the same 23-year period:
As shown here, stock valuations are also the highest that they have been during the past 23 years. It is still important to keep in mind that this is a period that includes the manic market of the technology bubble.
This brings us to the most commonly used metric for valuing stocks, the price-to-earnings ratio. However, the price-to-earnings ratio that is most commonly quoted is a relatively poor gauge of valuation because of all of the things that can affect it. For example, in 2001, price-to-earnings ratios throughout the market looked very high due to a broad earnings plunge and the exact opposite happened when the business cycle peaked in 2007.
In 2013, Yale economist Robert Shiller won the Nobel Prize for developing a metric known as the cyclically-adjusted price-to-earnings ratio that seeks to adjust for natural fluctuations in the business cycle. It accomplishes this by using the average of the past decade's inflation-adjusted earnings in the denominator of the price-to-earnings calculation. This chart shows how the cyclically-adjusted price-to-earnings ratio of the S&P 500 Index has varied since 1900:
As we can see here, while the market today is not as expensive as it was during the technology bubble using this metric, it is still much more expensive than its long-term average. It is also at a comparable level to where it was prior to the market crash of 1929 that launched the Great Depression. Shiller's research proved that any time the cyclically-adjusted price-to-earnings ratio is above its long-term median, long-only index investors will receive returns that are well below average.
Crescat Capital points out that there is a slight flaw in the cyclically-adjusted price-to-earnings ratio, however. That flaw is that it does not account for changes in profit margins. From the firm's letter to its investors:
"The Shiller CAPE of 31 today is in the same vicinity as it was at its peak in 1929 which it reached before the market crashed and sent the economy into the Great Depression. In Shiller's view, the 1999 Shiller CAPE sets the record for the highest ever P/E at 44. That fact that Shiller's CAPEs do not reconcile more precisely with our four prior valuation measures points to a slight flaw in CAPE.
Shiller's CAPEs simply need an adjustment for profit margins because margins are a key element of earnings cyclicality. We can understand this by looking at median S&P 500 profit margins in the chart below. For example, even though profit margins were cyclically and historically high during the tech bubble, they are even higher today. In the same spirit of Shiller's attempt to cyclically adjust earnings to determine a useful P/E, CAPEs need to be adjusted for cyclical swings in profit margins."
Here is the chart that the firm referenced:
As we see here, when the cyclically-adjusted price-to-earnings ratio is adjusted for the changes in profit margins, we see that stocks are now at their highest price relative to earnings ever, even higher than during the technology bubble!
As with Shiller's CAPE ratio, there is a correlation between margin-adjusted CAPE and actual stock market returns. When that is calculated, we get this chart:
This chart looks downright ugly for index investors. Not only is Shiller's CAPE ratio predicting lower returns than average going forward, but the profit margin-adjusted CAPE is actually predicting that the S&P 500 Index will have a negative return over the next twelve years. When we consider that various S&P 500-indexed securities make up the bulk of many peoples' retirement assets, this is especially worrying.
Enterprise Value-To-Free Cash Flow
This a very interesting metric that I do not believe I have ever seen used to value a security before. It is a very intriguing metric however and an improvement over the already discussed enterprise value-to-EBITDA ratio. In short, what this ratio should tell us is how much it costs to buy each dollar of free cash flow. In my view, free cash flow is more important than earnings so this might be the best valuation metric discussed in this article.
Crescat Capital believes that it is necessary to adjust this metric to account for the natural fluctuations in the business cycle as was done to the price-to-earnings ratio. In this case however, a three year cycle was used instead of a ten year cycle. Here then is the resulting chart:
As we can see here, the enterprise value-to-free cash flow of the median company in the S&P 500 Index is at its highest level in twenty years. Once again, this is a time period that includes the manic valuations of the technology boom.
The conclusion that we are forced to draw from all this is that stock valuations are currently at record high valuations. This is certainly something that investors will want to keep in mind going forward as this has historically resulted in poor returns going forward. At the very least, it would be advisable to take some money off the table or hedge your investments against loss (a long-dated put on the S&P 500 Index is one way to accomplish this).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have no direct investments in long-only Index funds. I am certainly exposed to market volatility through other holdings however.