July 22, 2014

What can the S&P 500 Price/Sales ratio tell us?

With the U.S. economy gaining momentum and the S&P 500 Index setting new highs, now might be a good time to see what, if anything, the S&P 500’s Price/Sales ratio — a measure of the stock market’s capitalization relative to its sales over the past year — can tell us about what stock market returns might be over the next few years.

Conventional wisdom says that, all things being equal, the higher the market’s P/S ratio is, the more expensive stocks are, and the lower future returns should be. To back-test this relationship, we plot the S&P 500 Price/Sales ratio (horizontal axis) versus subsequent 3-year return (vertical axis) since 1990, and find the chart’s downward-sloping data to be generally consistent with the conventional wisdom.

PS Ratio

While there is no way to know whether this relationship will hold in the future, we note that as of June 30, 2014, the S&P 500’s Price/Sales ratio of 1.75 was clearly above the historical average.  Taken in isolation, this single indicator implies a relatively low S&P 500 return for the next three years, all things being equal.

However, all things are not equal, and we don’t recommended that you base your outlook exclusively on a single indicator.  In today’s era of ultra-low interest rates, tame inflation, and rising U.S. consumer confidence and energy self-sufficiency, we may find that the S&P 500 will outpace the lowly expectations that the Price/Sales indicator would otherwise set.