For this holiday weekend, I will be presenting some different perspectives on market issues that have been very much under discussion in recent weeks and months.  For tonight's submission, I give you below the April 1st article from AAII regarding a concern that has been on many investors minds -- Are market valuations too high?  Enjoy the read and enjoy the holiday.  

4-1-21 Some Valuations Are Too High | AAII

Some Valuations Are Too High

by Charles Rotblut | April 01, 2021

Special Note: The U.S. financial markets and our offices will be closed tomorrow, Friday, April 2, in observance of Good Friday. We wish those of you celebrating the religious holidays a respective happy Easter and happy Passover.

Is there an upper limit to the valuations that investors in high growth and emergent stocks should pay? It is a question whose answer I discussed in last week’s VMQ Stocks commentary. I’m going to expand on the answer a bit more here.

There is an upper range to valuations even growth investors should pay according to Leuthold Group’s director of research Scott Opsal. Beyond a certain point, stocks underperform the broader market and, at extremely high valuations, cost investors money. Here’s what Opsal wrote in a recent report:

“A P/S ratio greater than 3 has essentially produced market returns, while raising the P/S limit to 6 produces a slight degradation in spread. This declining trend continues … until P/S ratios above 18 show zero absolute return and lag the market by more than 10% annually. A P/S ratio above 12 produces a clear deficit, but we felt that a P/S above 15, marked by a return shortfall of –5.8%, was the point at which we could definitively say that 15 is ‘too high’ to achieve consistent investment success.”

A price-to-sales (P/S) ratio of 15 is lofty territory. Out of nearly 4,900 exchange-listed stocks, just 530 have a price-to-sales ratio of 15 or higher. Most (80%) of these companies were not profitable last year.

High valuation. No profits. Not a good combination.

Opsal’s analysis matches the long-term data we’ve seen for other valuation criteria. Dartmouth professor Kenneth French’s online database provides historical data for the price-earnings and the price-to-book ratios. In both cases, there is a substantial drop in annualized returns for portfolios of stocks with valuation ratios ranking in the most expensive decile (most expensive 10%).

Portfolios comprising stocks with price-earnings ratios ranking in the most expensive decile realized an annualized return of 9.7% for the period of 1952 through 2020. This compares to an annualized return of 13.8% for stocks in the middle fifth decile and 18.2% for stocks whose price-earnings ratios rank in the cheapest 10%.

A similar story exists for the price-to-book ratio. Portfolios comprising stocks with price-to-book ratios ranking in the most expensive decile realized an annualized return of 6.9% versus 13.4% at the fifth decile and 18.7% at the cheapest decile between 1952 and 2020.

In both cases, returns rise as valuations become cheaper and returns worsen as valuations get more expensive. This is why both A+ Investor and VMQ Stocks assign a Value Grade of F to stocks whose relative valuations rank in the most expensive 80%.

Which ratios sit in rarefied air? Price-to-sales ratios ranking in the most expensive 20% are currently 8.7 or higher. Price-earnings ratios ranking in the most expensive 20% are 51.0 or higher. For the price-to-book ratio, the number is 6.9 or higher.

Is there a valuation metric you think is simply too high? Tell us in the comments section below.