Stuart Eliot

Senior Portfolio Manager

The equities bell is a long way from being rung

You may have heard that the share market is overvalued and that a major sell-off is just around the corner. We disagree.

In the short run it’s inevitable that equity markets will fall from time to time but, in our opinion, it’s not possible to reliably forecast these falls ahead of time. We are not the only ones to think this. In his latest letter, Howard Marks of Oaktree Capital Management quotes John Kenneth Galbraith: “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”

But is the market now intrinsically expensive? We don’t think it is.

1. Historically, returns are average

Let’s start by looking at recent returns in an historical context. Exhibit 1 shows the rolling 3-year total return for the Australian market. By this metric, recent returns are about average.

Exhibit 1: Australian equity rolling 3-year total returns. Combined index comprised of All Ordinaries prior to April 2000 and S&P/ASX 300 thereafter.


2. Price to Earnings ratios are within a normal range

Now consider the ratio of price to earnings (the P/E Ratio) for the Australian market as a whole. Exhibit 2 shows that the current trailing P/E (the market price divided by the earnings per share for the previous 12 months) is only slightly higher than the pre-2008, i.e. pre-GFC, average, so even if conditions were unchanged compared to before the GFC, the market is well within the normal P/E range and is no cause for concern.

However we differentiate between pre and post GFC here because we believe that the financial crisis caused a fundamental shift in both investment market and investor behaviour and so, in our opinion, the market is actually cheap on this metric (more on this in point 4).

Exhibit 2: Trailing P/E of Australian Shares. Source: Credit Suisse


3. The US market is fairly priced against earnings

We can take another, much longer, view on equity prices compared to earnings using data from Professor Shiller’s website.

Exhibit 3 shows the relationship between the S&P 500 index earnings and price over the very long run. The fact that the current reading lies almost exactly on the line of best fit calculated over more than 140 years of data may come as something of a surprise to anyone claiming that US shares are in bubble territory.

The data suggests that the US market is fairly priced given the current level of earnings.

Exhibit 3: S&P 500 Price vs Index earnings. Source: Yale, BTIM


4. Mathematically, Australian equities look fair

Inverting the P/E Ratio (i.e earnings divided by price) gives the earnings yield – the earnings of the stock market as a percentage of the price, which for the pre-2008 period was 6.5%. Let’s think of this average as a long-run pre-GFC “fair value”.

This earnings yield can conceptually be thought of as the risk free rate plus the Equity Risk Premium. Looking at the situation today, it’s hard to imagine the risk free rate averaging anything like 4% over any practical investment horizon. If we assume that the long-run risk free rate has fallen by 1%, averaging more like 3% in our example, then adding on the 2.5% ERP gives us an earnings yield of 5.5% which, when we invert it, implies that the post-GFC “fair value” P/E Ratio is 18.2.

Theoretically we can go further and argue the ERP may be lower now than in the past with interest rates so low. If the ERP has dropped 0.5% to 2% then we get an earnings yield of 5%, which then gives a post-GFC “fair value” P/E Ratio of 20. Under this set of assumptions and theory, the Australian share market is roughly 25% undervalued, but a small alteration to these assumptions does create a different result and we know what can happen when we assume too much.

As the old saying goes however, they don’t ring a bell for the top of the market but if they did we think it’s still some time until anyone rings it.

The argument for diversification

As diversified investors it’s not in our DNA to recommend anyone plunge wholesale into a single asset class like Australian equities based on the above analysis, as ultimately the appropriate mix of equities, bonds, property, alternatives etc is a function of the risk tolerance and return objectives of each investor.

However we do recommend that investors focussed on equities alone should consider diversifying their holdings between Australian and overseas markets as this is likely to generate similar returns with less risk.


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