Monthly Pillars Report

Can you believe that the  Price-To-Sales Ratio (PSR) of the S&P 500 is 25% more overvalued than the internet bubble years of 1999-2000? The reality is that I certainly don’t feel like we have the market enthusiasm of that period priced in and that is a good thing.

So what is going on with the below chart and why is the P/S of the market currently at 2.2x versus 1.7x in ’99-’00?  It’s called ultra-low interest rates and low capital expenditures. We have gone through an extended period of time where companies have used debt and operating cash flow to shrink their share base. At the same time, companies have made acquisitions using debt versus stock.

The good news is that a shrinking share bases and debt fueled acquisitions has resulted in stable S&P 500 earnings despite lackluster revenue growth. At the end of the day; however, stock prices are driven by earnings as the below chart indicates:

(S&P 500 Price level – Blue – Left axis; S&P 500 earnings – Orange – Right axis)

So what is the point of bringing up a high P/S multiple of the S&P 500 when earnings are the driver of the market? One must keep in mind that leverage cuts both ways. The economy has been stuck in somewhat of a low growth environment. From here, a much better or worse economic environment will cause a more dramatic swing in S&P 500 EPS.

If you are interested in discussing American Capital’s investment strategies, please feel free to give us a call.