Mike Spychalski, CAIA
Since the current bull market began in March 2009, the S&P 500 has posted an annualized return of 19.5%. During that time period, the trailing 12-month price to earnings ratio (P/E ratio) of the S&P 500 has increased from 14.2 to 18.1 (an increase of 27%). Over that same period, the trailing 12-month price to sales ratio (P/S ratio) has increased from 0.8 to 1.8 (an increase of 118%). The current P/E ratio of 18.1 is below the 20-year average P/E ratio of 19.2 but above the longer-term average P/E ratio of 16.7. The current P/S ratio of 1.8 is greater than the 20-year average P/S ratio of 1.5 and is higher than it has been at any point since 2000.
As seen in the chart, the P/S ratio has grown at a much steeper rate than the P/E ratio during the past few years. Over this period, the growth in earnings per share of the S&P 500 has significantly outpaced the growth in sales per share. This tells us that cuts to bottom line expenses — not growth in top line revenues — have been the primary driver of earnings growth. It is fairly typical for this scenario to occur, especially in the early stages of a bull market, as companies tend to cut expenses in order to remain profitable following downturns in the economy. However, in order for earnings growth to be sustained over longer periods of time, there needs to be a pickup in sales growth, as there are limits to expenditure cuts. This is especially concerning because current forecasts indicate that the market expects negative sales growth for both the first and second quarters of 2015. To be sure, this may just be a statistical quirk caused by the significant drop in oil prices in recent months, but it bears monitoring nonetheless.
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