July 23, 2024
Hello and welcome. My name is Matthew Sterns. I'm the founder and lead adviser here at Brook House Advisors in Medeville, Pennsylvania. We have a special presentation for you today. This is for clients and the public that I call "Into Thin Air: A Look at U.S. Stock Market Valuations" and all the things that I think investors should be keeping their eye on right now as we head into the second half of summer.
Just as a disclaimer for today, this presentation expresses my views and that of Brook House Advisors. There's no guarantee that they will be accurate; they may, of course, prove to be wrong ultimately, and none of this presentation has been reviewed for accuracy by FINRA or the SEC. My registration with the State of Pennsylvania does not denote any level of expertise.
Okay, certain market information that's in this presentation was obtained from public sources, and I believe those sources to be accurate and reliable, but I do not assume responsibility if they are indeed not. I think they're close enough to be useful. This presentation is for informational purposes only. This is not investment advice. I'm going to be giving you a lot of data and facts, but I'm not going to be telling you what to do. I think it's important to just know where we stand in this particular environment and that if you're watching this, you should be in conversation with your own professional, your own financial advisor, understanding the risks that you're taking and the suitability of the investments that you have.
So today, we're going to be talking about the valuation of the entire U.S. stock market. By "U.S. stock market," I'm going to primarily be referring to the S&P 500. The S&P 500 is the 500 largest companies in the United States by market value, but we're going to be talking about the entire market for all intents and purposes, which would be anything within the top 3,000 stocks in the United States stock market. There are a couple of very basic valuation metrics that we use to determine the valuation of a company based on historical factors.
Okay, again, these are the economics 101 valuation metrics, so you shouldn't take these ratios and go and look at an individual stock and say, "Oh, this stock is expensive," or "This stock is cheap." It's not how it works. But today, we're going to be talking about these ratios because when you're looking at an entire market, they provide a little bit more context than an individual stock that has a lot of individual circumstances and nuances that need to be considered.
So, the price-to-earnings ratio is quite simple. It is literally the value of the company divided by its net income over the last 12 months. You take its net income and its price, and then that gives you a ratio. It might be 10, 20, 30, or 40 times its earnings. You could say a company has a P/E ratio of 40; it is priced at 40 times its net income in that situation.
Then we also have price-to-sales, which is pretty straightforward. It's the value of the company divided by how much sales it had in the last 12 months. There are a lot of types of valuation methods—too many to count. Price-to-free cash flow, which is a little bit different than earnings and net income; you have forward P/E, projecting what the future 12 months is going to be, etc. But the classics that we're going to be talking about today are price-to-earnings and price-to-sales.
Okay, so we're going to start by looking at the historical price-to-earnings ratios going back to 1988 compared to where we are today. You can see that we've had quite a bit of variation throughout the last 36 years, with as low as a 12 P/E ratio in 2010 and 2011, and now we're at about 26. The historical median that they're showing here is 18. If you went back to about 1900, the average P/E ratio would be 15, so somewhere between that 15 to 18 mark is historically relevant, or about what the average has been.
The reason that it's 15 to 18% is for a very good one, and that is that investors—people that are purchasing businesses, whether it be shares or entire businesses—are only willing to pay a certain amount of the earnings multiple to purchase a business. It's quite fundamental. If you were an investor buying a small business in your local town, how much would you be willing to pay if they were making a million dollars in net income? How much would you be willing to pay for that business? If they're making a million dollars, would you be willing to pay 5 million? You know, it would take you 5 years to get paid back. Would you be willing to pay 10 million? It would take you 10 years to get paid back if they kept that current rate.
Historically, in the fastest-growing companies—because these are the top 500 companies in the United States—people are willing to pay about 15 to 18 times their earnings. The reason why that number is a lot higher than you would think logically is because these companies are growing at a fast rate. That's why they've become some of the largest companies in the United States.
In that situation, you're saying, "Okay, I'm paying for 15 times their earnings today, but in 5 years, I expect their earnings to be double that, so I'll pay 15 times today's earnings." Whereas, if you were buying a small business, most small businesses in fact only sell for about three to five times the earnings because you don't expect that much growth on it. So, if some company was making a million dollars and you want to buy it, it would probably only be worth $3 to 5 million.
Okay, this is how valuations work because they're rooted in the fact that if someone was buying your company, they wouldn't pay an infinite amount for that company, right? They would pay a certain amount of future cash flows, and that number is typically around 15 to 18 times. This is one of the most mean-reverting things over a long time frame that the markets always return to because it's a logical number to be willing to pay for the future growth of a normally growing organization.
Profit margins historically are around 10%, so if you have a company growing at 10%, and you're buying a large company, you're on average willing to pay 15 times for that. Now, an individual company might fetch a higher multiple, a higher P/E, because they're growing at a 20% or 30% clip, but that's the risk of investing in a growth stock. You have to monitor how much is that company actually going to have to grow and how many times their current cash flow, their current net income, and how much am I willing to pay to own that company. This is the fundamentals of investing.
Right now, the S&P 500 is at 26 compared to an ordinary number of about 15 to 18, so it's about 40% overvalued based on this metric.
Next, we're going to look at the price-to-sales ratio. The price-to-sales ratio is very straightforward: what's the value of the company divided by its sales? You know, that's the ratio that we're looking at here. The historical number in this chart, we're looking from 2000 to today; the historical number going back to 1900 is closer to 2. So, we've actually been a little bit lower than the median, largely because of the financial crisis in '08.
Today, you can see that the price-to-sales ratio is well above the median at 3%. Like I said, historically, it's actually about 2. So, on this metric, the price-to-sales ratio today, over the last 12 months, is about a third to half to 50% overvalued as well.
All right, this is a great slide and one that I really want to focus on today. That is looking at the price-to-earnings ratio and the price-to-sales ratio of different slivers of the market. As we mentioned two slides ago, the S&P 500 today is at 26 in price-to-earnings; the average is about 18 to 15. Okay, the equal-weighted S&P 500 is a little bit different than the S&P 500. The S&P 500 is weighted, so if the size of your company is larger, you comprise a greater percent of the index than a smaller company. For example, Microsoft is 6% of the S&P 500, while Disney might be half of a percent of that index. Conversely, in the equal-weighted index, they all share the same weight, so they're all worth about 0.21% across the board. The equal-weighted index is a little bit cheaper, but still overvalued relative to historical levels. The Russell 2000 includes your 2,000 smallest publicly listed companies. Technically, the Russell 2000 is the 1,000th largest to the 3,000th largest stock, so we call those small-cap stocks. You can see it's at 38 times, while the NASDAQ, which is comprised mostly of technology companies, is at 44.
But this is the big one, folks: the Magnificent Seven stocks that everybody loves: Tesla, Nvidia, Meta, Google, Apple, Amazon, and Microsoft. These stocks are trading at nosebleed-level ratios of price-to-earnings, meaning people are willing to pay 53 times their net income today, which is at all-time highs, experiencing extreme levels of growth in most cases. They're at a 53 multiple relative to a normal amount that would be 15 to 18. I know what people are saying: their first reaction is, “Well, these are great growth stocks; they've been growing so much.” In fact, large companies, think about Apple, have been around for almost 50 years. They get so large that they actually experience, or normally experience, slower growth than a company that might be the 400th largest company. That’s really kind of moving up the ladder; you get to this size and scale, and it's just hard to grow a $3 trillion business as fast as it was when it was a $300 billion business. Okay, it's just a matter of mathematics.
So what should normally happen is that the largest companies should have an even lower multiple than the smaller companies. The fact that the largest seven companies have a 53 multiplier, with people willing to pay 53 times their earnings, is something to really think about. Okay, let's look at price-to-sales. You can see in this situation that if you recall, the S&P 500's at three right now; the historical average is two. You have the Russell 2000, small-cap stocks, and equal-weight 500, which are fairly or even undervalued by this metric. But then look at the NASDAQ: you still have the NASDAQ almost doubly more expensive than normal. And then look at the price-to-sales ratio of the Magnificent Seven; it's just unbelievably high. This is because they've been earning really high profit margins on their sales, so their earnings ratio looks closer than their sales ratio does. But their price-to-sales ratio right now is about five to six times—let's call it six times—the average. So you're looking at an 80% decline in that metric to get back to normal levels.
Here's another look at the five largest stocks in the S&P 500, looking back historically. This goes to 1964, and you can see that right now we have a very large concentration in our top five; the top five comprise roughly 30% of our stock market. You throw in the rest of the Magnificent Seven, and they're over 35%. Okay, so these companies are making up a huge chunk of our market, a disproportionate size, and it hasn't been this big since you have to go all the way back to the '60s. You can see that there is a trend here, with growth and decline as these things kind of rotate. This isn't something that is historically normal. There is, however, precedent for it, but the precedent is that these things usually wind themselves out over time. But this is important, and something I'm going to reiterate in this presentation: just because this was the high in the past does not mean that it can stop here. These companies could become 50%; they could become 70% of our stock market. Nobody knows how far this is going. This is not me saying, “You know, these stocks are way too big; you should sell them.” That's not what I'm here to say. What I'm saying is you should just be aware that these companies are representative of a huge amount of the S&P 500. If you own the S&P 500 index, you have to understand that a third of what you own is in seven companies—okay, five to seven companies. That's what I'm here to tell you. That's all. This metric can go very largely in a very large magnitude in one direction or the other.
Okay, there are some cautionary tales, however, that I think are worth mentioning, and this is related to a point that I think is really forgotten by investors. In this chart, we're looking at Cisco in 2000 and Nvidia today. Now, in 2000, we had what was called the dot-com bubble, and that bubble was really focused on the internet and how much the internet was going to change our economy. We're here 24 years later, and the internet changed the economy massively—just like the Industrial Revolution changed the economy. Okay? So, massive, massive change. But what happened in the late '90s and 2000s? Everybody said, “Oh my gosh, this internet is so revolutionary; it's going to change everything. Let's just buy all these stocks, and let's buy indiscriminately. I don't care how much it costs; buy, buy, buy.” At that time, Cisco was really the leader in internet servers. They're still around, and they still apply to a lot of the aspects of the internet. But what happened was people forgot that it mattered how much you paid for the company. So, even though Cisco is still around today, even though it is much more valuable today than it was in 2000, you can see that we have an overlapping chart here. This is the white line shifted 24 years ahead. You can see how steeply that chart— that stock price went up in two years. It was just this massive bubble that was formed. Then you can see over the next two years that that stock price corrected 80%.
Now, were people wrong about the internet? No, they were absolutely right. Were people wrong about Cisco? No, great company, still around today, worth much more than it was. But people were wrong at that time to pay any amount for the company, even though they were part of this earth-changing technology. This is something that so mirrors the situation we're in today. Wisely, this chart overlays this with Nvidia. Nvidia is right now the second or third largest company in the United States. You can see the meteoric rise in their stock price. Now, Nvidia makes semiconductor chips that go to a lot of computer applications, but they're really making a lot of money from artificial intelligence applications and crypto—two of the most buzzworthy, trending things right now that are probably going to make a huge impact in our world. But here we are again, with people saying, “Oh man, this is such transformative technology; Nvidia is the biggest player. I got on Nvidia!” Right now, Nvidia's company value is as a percentage of GDP of the United States—GDP is about 12%. So, relative to their impact on the economy right now, it's valued at 12%. Cisco was 5.5% in 2000, and their stock price corrected about 90%. It went down 90% from the peak. You can look at the magnitude of this Nvidia stock so far this year. It's just a really important reminder that you can own a fantastic business; you can own it in the most fantastic industry doing the most groundbreaking thing. It still matters the price you pay, and it will always matter. The return that you earn on an investment is a function of the price you pay, and it's not worth an infinite amount; it's only worth a certain amount. Okay, so just be very aware of that today. Things seem really trendy and they’re moving very quickly in either direction based on word of mouth or the new buzzwords. Just think back to this chart.
Okay, so now we're going to take a look at Apple, which has been more of a stalwart. They've been around a long time, so a different type of chart here, but we're going to look at the individual P/E ratio of Apple. You can see here this chart only goes back about eight years, but even in the last eight years, Apple's price-to-earnings ratio was averaging about 21. Right now, it's at 35. Okay, just keep that in mind. The EV-to-EBITDA ratio is quite similar; it's basically looking at the price-to-earnings ratio but then excluding depreciation and amortization and interest expense. You can see that its average was 15, and it's at 26, 27 now. Then look at the price-to-sales ratio: the price-to-sales ratio normally averaged 5% over the last five years—excuse me, the last eight years—and now it's at 9.27. So, all of these metrics are almost 60%, 80%, 100% overvalued in these metrics.
And this is Apple. And the interesting thing about Apple is that in the last two years, since 2022, Apple's revenue has not grown. Their sales have not increased in the last two years; they've flatlined. If you look at their revenue chart, zero growth. Apple right now is a zero-growth company, and we don't know if they're going to keep growing. Quite frankly, yes, they have a dominant product, but many in the world can't afford their products. In China, they're making excellent phones that are very comparable. I lived in Hong Kong in 2014, and at that time, the Chinese were already switching their preferences to the local phones. I saw a lot of my European friends buy them. They took them home; they loved their phone. Okay, it's very good, and they're selling at 25% to 50% of the price.
Does Apple have a permanent product that they can grow infinitely at 15%, 20%, whatever it may be? I'm not sure. But Apple right now has a PE ratio of 35. They're not growing; they haven't grown for two years, and the average is probably around 20 for them if you look back historically. Again, these are valuations; I'm not telling you what to do. This PE ratio can go to 70; I have no idea if that's going to happen. But just be aware of it; that's what this presentation is all about.
All right, so here I'm going to bring you a couple more sobering charts. This one, well, both of them are by John Hussman, who is an economist that I greatly respect. He's also a mathematician, and he just does some phenomenal work. He's been at it for a long time. He very precisely predicted that the technology crash of the 2000s, the dot-com bubble, like I was referring to with Cisco, would be extreme. In fact, I think he predicted that it would be down 83%, and it was exactly an 83% correction in those stocks.
This chart that I want to look at today is really good because it looks at sort of an estimate. If you look at the x-axis on the bottom, what are we estimating? The 12-year return versus what's actually happened historically? Okay, so this is in excess of Treasury bonds. Whatever the interest rate you're getting on Treasury bonds is, you know, for example, it's right now between 4% and 5%. It would be, so like, what's the return beyond that 4% and 5%? For example, and you can see that there's a pretty strong correlation between the estimate and the actual. We've got a pretty linear relationship.
He identifies the estimate; he calculates the estimate based on a proprietary valuation model that is really close to the price-to-earnings ratio, but eliminates banks, eliminates some certain sectors, and adjusts it based on profit margins and some other things of that nature. But interestingly, in his chart, he is estimating that the 12-year annualized return of the S&P 500 is going to be about 10% less than Treasury bonds, like I said, over the next 12-year time frame. Now, that doesn't mean every year they're going to underperform, and that doesn't mean that every year stocks are going to go down. That could mean that Treasury bonds are going to do phenomenally well; stock prices just might not do very much. Or it could mean both Treasury bonds are going to do great, and stocks are going to do poorly. You don't know exactly what's going to happen by looking at this, but you can see, based on this data, that there is a strong relationship.
Even the dots that are furthest from the correlation line—that's really a little dotted line—are only off by about 7% or 8%. Okay, and right now, he's at negative 10%. So if he's as wrong as he's ever been, it's still saying that it's inferring that over the next 12 years, the S&P 500 is not going to outperform Treasury bonds.
All right, here John Hussman and his team also take a look at valuations and look at, you know, what does valuation need to be to earn a 10% normal return? A nominal return, so not thinking about inflation, which would be the historical average of the S&P 500. What does the price need to be? What does the valuation of the stock market need to be to get us to that level that's consistent with, you know, expecting to earn 10%?
All right, and in this chart, he says that that level is 3,650. Okay, on the S&P 500, right now it's about 5,600. He's saying it could go as low as 3,600 to get to a point where it's about a 5% premium over Treasury bonds. He's saying 4,700 to get to where Treasury bonds and the S&P 500 will return about the same thing based on valuations. He's estimating that the S&P 500 level needs to get to 2,600. So in this situation, you know, John's expecting, based on the calculations of the valuations of the market, that there needs to be a pretty severe correction to return ourselves to a situation where the stock market is traditionally valued at a fair price.
Okay, and that's what I want you to hear. For the stock market to be valued at a fair price, where you as an investor can expect a long-term 10% return, the market is just much, much too high to have that expectation. Okay, now that doesn't mean the market won't go higher in the future, but, you know, in the next medium time frame, you know, if you're expecting those large returns, you may be mistaken.
Okay, and this isn't, again, advice on what to do next because you can see how far, you know, that blue line that you're looking at, that graph—that's the S&P 500. You can see it kind of gets away from the green line, which is really kind of the normal level. But it's extremely far away today, and it can keep going to extremes. We live in a crazy world. We're going into extreme amounts of debt; certain things in this economy can keep going in extreme ways and extreme directions further than anybody thinks is possible. So this is not a recommendation about what to do; it's not a recommendation to not own stocks; it's not a recommendation to own stocks or anything about the Magnificent 7. This is a recommendation to understand that the market is historically expensive.
Okay, there's really not two ways you can cut it up where that isn't the case. Okay, but we don't know what's coming next in the short term. But we can know how expensive it is, and we can also look at our portfolio and say, "All right, you know, what am I really at risk here?" And that's the key question. You know, it depends on what you have in your portfolio and how much you really have at risk, and if you're okay with taking that risk. Because, like I said, the market could keep going up, but do you understand the amount of risk you're taking for that growth, and are you comfortable with that? If you are, then stick to your investment plan by all means. If you're not, you need to talk to your adviser, and if he's not understanding it, you need to talk with somebody that understands these types of dynamics at a deep level.
Okay, just a few more things. So I kind of started this rant on the last slide, but you know this is not investment advice. This is about knowing what you own and understanding the risk that you're exposed to. Okay, I'm not calling for a market crash; I am saying the market's highly, highly expensive. I'm comfortable saying that, and it is most expensive in the biggest and largest and flashiest names that I think I can say, you know, is a fact. Okay, and as an investor, you need to understand that if you own the S&P 500, you own a huge chunk of those names; they're the most expensive portion, and the other parts of the market are less expensive.
Okay, you have to weigh and balance what that means for you. Valuations are not a good indicator in the short run of what's going to happen. The last thing you should do is take this and, you know, apply it to your portfolio tomorrow. Okay, well, I shouldn't say that's the last thing you should do, but this is not indicative of what's going to happen in the short term. In the short term, it could be, you know, in the next 24 months. Okay, but valuations are mean-reverting because investors can't pay an infinite amount for things. Investors are only willing to pay a certain amount for future cash flows. If you were actually buying an entire business, you would care a lot more about the price you're paying for it. If you had the money to buy, you know, a business, you would not be paying, you know, 60 times their net income to purchase the company; you would not be doing it.
These are prices people are paying because they're betting that somebody else will buy the stock at a higher price. Okay, and eventually those things return to normal. You know, something happens; there's usually some type of catalyst. So valuations are predictive of long-term returns because so are profit margins and people's willingness, you know, to actually purchase companies, which is what you're really doing when you're buying stock.
So I hope, you know, I put a good wrapper on that, and I hope you got a lot out of this presentation about valuations of the stock market. It's not to scare you; I'm not a bear; I'm not, you know, rooting for the market to go down. But I am concerned about people's awareness of where things are, kind of how frothy the market is, and that, you know, the long-term prospects are much reduced because the market is so expensive. Um, and so, there's an opportunity there in the future, and there's, you know, more risk than normal here at our current times. So, know what you own and understand your risk.
All right, so that's everything I have for you today. Thank you very much! Thank you for watching this presentation brought to you by Brook House Advisors. We're a Christian investment company; we do active portfolio management. We actively manage risk for our clients. We also use faith-based investment options that align with Christian values. We do financial planning, retirement planning, and 401(k) servicing for businesses, and much, much more.
So, if you enjoy this presentation and are looking for some other opinions on your investments or financial situation, please reach out to us. You can find me at brookhouseadvisors.com, schedule a meeting there, or email me at Matt@brookhouseadvisors.com. Thank you very much!
