Any advance beyond 2,000 for the Standard & Poor’s 500 Index will have to overcome relatively high share prices. The above chart shows the S&P 500’s price-to-sales ratio. The more common valuation metric, price-to-earnings, can be susceptible to manipulation through “creative” accounting but a less nefarious reason is that earnings can expand simply due to corporate cost cutting and improved productivity. Earnings expansion without a commensurate increase in sales can hide underlying structural problems in a company and thus financial markets. This trend can dramatically affect the price-to-earnings ratio making it a less reliable measure of corporate, as well as the broader economy’s success. While price-to-earnings is, and likely will remain, the industry standard, we feel the price-to-sales ratio can give a more accurate long-term view of the financial success of the consumer and business sectors and hence the economy.
This week’s P/S ratio of 1.7748 was the highest since June 2001, according to data compiled by Bloomberg. The reading was 16 percent higher than the average since July 1995, as shown in the chart. At these trading levels, valuation is the market’s biggest headwind and sales will have to catch up for stocks to sustain the five-year bull market or the markets will need a corrective move that will bring valuation metrics back to historical levels.
The recurring theme of extremely low volatility and overbought conditions have remained consistent within the financial markets. As such, we have begun to step up the level of trading and risk (position size) proportionate to our confidence that our trading models will respond properly. We are currently net short with several positions and are monitoring them day and night. We feel the markets are exhibiting an unsustainable upward bias and we are confident in our research that the markets will normalize. We are beginning to see divergent behavior between various indices further supporting our research and strategy. With the markets fluctuating hourly, we have been trading around the core net short position and repositioning for a reversal that is long overdue.
Over the last month we initiated (in stages) a hedge on the S&P, Nasdaq and Dow indices which gives us a 25% protective hedge on the portfolios. Along with the hedge, we will carry cash weightings in the portfolios between 10% and 15%.
When the market correction runs its course and/or the markets tell us that they want to move higher based on our research, we will remove the hedge and begin the process of getting back into the markets and get fully invested. Until then we remain diligent in our research and will continually monitor the markets and report back at the quarter end.