With the U.S. stock market at historical highs, investors may be questioning if stocks have become too expensive and whether now is the right time to stay invested. But if investors exit or avoid the market, they could miss out on the potential long-term returns stocks deliver. Trying to determine the best time to get back in the market can be an impossible exercise. For investors, we believe the question isn’t “Should I Invest in Stocks?” but rather, “What Is the Best Way to Invest in Stocks?”

U.S. Stock Values Are Near Historical Levels

In 2017, the stock market has soared to record highs. A way to gauge if those prices are warranted is to look at “valuations,” which is a measure of stock prices in relation to a measure of the underlying companies’ worth, like earnings or revenue. On a price-to-sales (P/S) ratio basis, stocks are near historically high valuations. In fact, we haven’t seen P/S ratios at these levels since the tech bubble (Exhibit 1).

Large-Cap Valuations Are Approaching Tech Bubble Highs

Many investors participate in the U.S. stock market through passive strategies, which mirror an index and weight securities by each company’s market capitalization. As the market appreciates, investors in market-cap strategies will have greater exposure to stocks that have increased in price and may no longer be as attractively valued.

Revenue Weighting Provides Value and Stability

An alternative approach to avoid the risk of overpriced stocks is to weight securities by companies’ revenue. This weighting strategy results in greater exposure to value-oriented stocks. Rebalancing the portfolio every quarter, according to each company’s latest revenue numbers, helps the portfolio avoid exposure to overvalued stocks. The benefits of this discipline became evident during the tech bubble as a revenue-weighted portfolio had much less exposure to companies that became more richly valued than market-cap-based indices did (Exhibit 2).

Revenue Weighted Strategies Rebalance Toward More Value-Oriented Portfolios

Low Valuations Today Are Important Indicators of Future Returns

To determine the merits of focusing on stocks with low valuations, we analyzed whether low price-to-sales (P/S) ratios have been an accurate predictor of stock returns. We found that a low P/S ratio—meaning stocks were attractively priced—was frequently followed by high returns over the next 10 years.

To determine how effectively P/S predicted returns in comparison with other valuation metrics, we extended our analysis to include the price-to-earnings ratio (P/E), price-to-book value (P/B) and price-to-cash-flow (P/CF) ratios over different periods. In this analysis, we used a statistical measure, R-squared, which provides a statistical confidence level for how predictive one variable’s movements are of another’s. The important detail to note here is that the closer R-squared is to 1, the higher the relationship is between two attributes. As can be seen in Exhibit 3, for short-term periods of 3 years or less, none of the valuation metrics appear to be an effective predictor of returns. Over long-term periods, such as 5 and 10 years, the P/S ratio has been an effective predictor of returns—and a much better one than any of the other valuation metrics (Exhibit 3).

Ratios as a Predictor of Furure S&P 500 Price Return Using R2 Quarterly 1991-2016

Investors face a challenge today, constructing portfolios at a time when stocks may be considered expensive. Revenue weighting offers the means to focus on a key company fundamental—revenue—to target companies’ economic contributions as opposed to market cap. This approach can provide disciplined and consistent exposure to the market.

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