Just three long months ago (2022 already feels like a decade), I wrote about the “liquidity bubble” potentially popping in a previous COTW post. Well, just 90 or so days later, the answer appears to be clear: unequivocally, yes. The Federal Reserve (Fed) has not done much of anything yet, but the markets have priced in 11 interest rate hikes — or a federal funds rate of 2.75% by 2023.
In addition, the Fed is expected to reduce its balance sheet. This policy reversal is significant. The shift away from the most aggressive and accommodative central banking policy in history, intended to combat the pandemic-induced market decline, has happened in an incredibly tight time frame. The magnitude of the Fed and U.S. government stimulus packages were unprecedented. Their combined effect on corporate earnings and stock market valuations altered the course of market history.
The stock market took its cue from the Fed and drove stock prices and valuations to unrealistic levels. This short-lived euphoria echoed prior market peaks. But nowhere was the impact felt as clearly as in company valuations. There are many valuation measures that we can review. However, in my opinion, the cleanest one to use is price-to-sales (P/S) ratio, primarily because sales are much less likely to be manipulated by company management. It is much easier to massage net income or EBITDA, but sales are usually pretty clean.
The Fed’s impact was felt across the stock market and, as it is about to tighten, the reversal of this effect has been felt swiftly and harshly. Growth stocks, in particular, became completely unchained relative to historical standards. Below is a selection of tech companies and their P/S multiples from last October (not even their highest levels) when the Nasdaq Index peaked, along with their current levels (after realization hit that the Fed was about to shift its monetary policy):
|Company||Ticker||10/31/21 P/S||Current P/S||Decline in P/S|
Source: Bloomberg; Current P/S data is as of 4/27/22
Further, to give us some historical context for the broad stock market, the average P/S for the S&P 500 Index from 2002 to 2012 was 1.4x. From 2012 to present, the average P/S for the index was 2.0x. While that might not sound like a huge difference, an increase of 43% is significant. Even worse, the S&P 500 Index P/S multiple just peaked in December 2021 at 3.1x. This represented an increase of more than 50% even from the elevated levels witnessed during the past 10 years.
A side-by-side comparison of the market’s price-to-sales multiple and the Fed’s balance sheet is the clearest example I can give that ties stock price valuations to the substantial Fed liquidity injections into the markets over the past two decades. More recently, the Fed blew a bubble that led growth investors to place record valuations on what is turning out to be unsustainable growth. The broad market is in the same situation, just not nearly to the extent we have witnessed with growth companies. And while we have no idea of what is to come for the markets, I believe it is clear that the “Fed Put” and the “buy the dip” mentality are over for now. This will require an adjustment in market psychology going forward.
It is my contention that underlying company fundamentals will matter even more now than before as Fed liquidity declines. The Fed’s influence covered up bad decisions, some bad investor behavior and a lot of malinvestment. This has been clear in 2022 as price-to-sales multiples for many growth stocks contracted significantly. Stock prices do not always trade in line with underlying company fundamental values…but eventually, value wins out. Knowing what you own, why you own it and the price that you pay for each security was always important. As the saying goes, “Price is what you pay; value is what you get.” We will continue our search for low to reasonably priced securities that have true value and a margin of safety to justify their place in our portfolios.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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