Cheap At A Price

Australian shares have given local investors an average compound capital growth of 9.5 per cent a year since the dust of the 1987 market crash settled. The accumulation index, which includes dividends, has risen even more.

This powerful rise has been maintained through several business cycles, changes of government, currency swings and dramatic external crises. We have experienced drought, a global boom and bust in technology stocks, carnage in Asian and European markets, a seemingly endless recession in our major trading partner, wars in the Balkans and the Middle East, and terrorism worldwide. Every setback has been quickly overwhelmed by another surge in share prices as doubters ran for cover. And every advance has won more converts to the equity cult.

The explosive advance of the past two years has stunned even the optimists. An almost uninterrupted gain of over 60 per cent followed the 2002 bear market and the mild two-month correction into May this year only trimmed that rise by 8 per cent. Since then the broad market index has risen 14 per cent. Surely this record-breaking run can't go on? Will the pessimists be right? And will we soon roll over into another decline? Or are there plausible reasons for expecting prices to go even higher?

Every market is a battleground between conflicting expectations. Each side has its arguments and justifications for expecting a rise or fall. I want to tell you of my confidence in the future trend of values and about the real cyclical risks that are causing unease in the markets. I will try to be as fair as I can by first allowing the pessimists their broadsides before I return fire. You must be the judge of the encounter.

Q: Are the optimists claiming that the economic cycle is dead? The Australian sharemarket is priced for persistently strong economic growth at home and by our major trading partners '” but the cycle is very old by past standards and the traditional "speed limits" of rising supply bottlenecks, inflation and interest rates will soon trip us up. Profits and share prices must fall, perhaps by a lot, as growth slows to "normal" around the world.

A: The cycle is certainly not dead, but its profile has been drastically altered by the new global structures of free trade, deregulated capital and technology flows, and the convergence of economic policies around the world. Economic volatility has fallen as a result. The traditional cycle of frequent localised spurts and slumps in activity has been largely replaced by an environment of longer and flatter trends as the world becomes more tightly integrated.

Research by Melbourne's Capital Research consultancy illustrates Australia's transition from stop-start conditions to a longer, flatter, more predictable growth cycle, especially since the late 1980s. Capital Research's chart of GDP volatility also shows the clear link between the decline in economic uncertainty and the fall in the risk premium demanded by investors for holding cycle-dependent assets such as shares.

The "past standards" of the economic cycle's age or shape can no longer be a reliable indicator of its life expectancy. The old local speed limits could also be obsolete because new trade freedoms have opened up sources of supply of cheap manufactures in the lower-cost developing economies, and this will keep inflation low because price competition and job insecurity remain intense everywhere.

The new environment automatically produces low inflation despite external price shocks in such basic commodities as oil, minerals and foodstuffs. These shocks can no longer be concentrated and amplified through wage structures in particular key economies. Instead, they are transmitted quickly and cleanly throughout the global economy and are dissipated before they can do harm.

Low and stable inflation in turn encourages high real growth. What is "normal" under the new economic regime is considerably higher than it was in the past. Since inflation is really a tax on growth, any economic environment that encourages its long-term decline produces the same effects as a continuing tax cut. Activity accelerates, efficiency improves, confidence rises and profits go up. So do share prices when interest rates follow inflation down '” and share valuations are ultimately calibrated to the level and direction of interest rates in an economy.

Q: This "new environment", in theory, sounds wonderful, but how sustainable is it likely to be in practice? Aren't the social costs of this business-driven global integration too high, especially in the democratic nations of the First World? And won't this latest attempt to integrate the world under one market system inevitably collapse into chaos, bringing all the markets down?

A: This is certainly the biggest risk to the optimists' case. Any return to the pre-1990 divided-world environment would quickly bring back the old boom-bust conditions and the high-inflation, lower-growth consequences for all market values. But there are few signs at all that this is likely, despite the unpopularity of the globalised system in many quarters and the political pain of managing its wrenching effects. The benefits are simply too great to be universally abandoned, and nobody can now afford the risk of individual economic disengagement.

The new global system's trial by fire came at the time of the 1997-1998 Asia markets meltdown, and it emerged strengthened and tempered. It would probably take a world war to break the new regime apart now '” and not even the greatest pessimists are predicting that. If it were to happen, of course, Australia and its stockmarkets would be in no better shape than anywhere else. I see no evidence that globalisation has raised the risk of such catastrophe. Rather, it promises to spread growth, opportunity and wealth much more widely than ever.

Q: Even if we accept that the new global regime is sustainable, why should the changes that it causes in the shape and duration of the economic cycle create such a big and persistent upward shift in share prices?

A: Because the new environment has become more predictable and less risky for companies as well as investors. An unstable cycle punctuated by dramatic ups and downs makes the outcome of every decision highly uncertain. That decreases efficiency and raises the real costs of doing business. It also creates short-termism, waste and defensiveness, and it paralyses long-term strategic planning by management. The result is unpredictable corporate performance.

That unpredictability requires a higher premium from shares, above the return an investor can get from risk-free near-cash assets. When the cycle becomes more regular and the expansions last longer without meeting the old speed limits, the sharemarket gets a triple whammy: company earnings go up and stay up; interest rates come down and stay down; and the market-risk premium does the same. The result is the sort of shift in share prices that you now see.

That "phase shift" makes share prices look expensive compared with history, but I think that is an illusion caused by a deep misunderstanding of what is really happening at the structural level. People confused by strange developments will always look for explanations from the familiar past. But the past throws a very deceptive light on the completely different world scene that we are working in now '” and, as I have argued, that new scene shows no signs of backsliding.

The most basic thing to understand is that the market's main job is to discount the future and not to cling to the past, even if the windscreen may not always be as clear as the rear-view mirror. The opportunities and risks are always ahead, never behind.

Q: Perhaps the new environment is benign for sharemarkets, and perhaps that won't change soon, but what about the situation of Australian companies? Surely their share prices must still look speculatively high as our business cycle dies down? Despite the correction we have already had. Won't the market now be caught between an earnings decline and a rise in interest rates from now on? Isn't this what real bear markets or even crashes are made of?

A: Not necessarily. A real bear market is unlikely unless there is such a combination of external shocks that the new investment regime changes altogether. I don't expect that to happen, and neither do even the biggest pessimists. I think of a genuine bear market as a condition in which even long-term investors are forced to crystallise their paper losses.

A normal market correction causes pain only to short-term traders, who may be forced to sell to investors with longer vision and deeper pockets; whereas a market crash tends to trap everybody because liquidity dries up.

Crashes represent a rapid and disorderly unwinding of speculation and are caused by a cascade of events that usually involve policy mistakes acting on excessive market leverage. I don't see the Australian market as crash-prone because there is very little evidence of serious leveraged involvement (by hedge funds or anybody else) even in the more traditionally speculative minerals and property sectors. The chance of policy mistakes is always present but the Reserve Bank continues to show great caution and skill in managing the vital interest-rate and inflation background, and budgetary policies are also conservative by world standards. Again, this looks unlikely to change for any political or other reasons in the near future.

The Australian market's stellar price performance, under the new investment regime, has been underpinned by matching growth in profits and dividends. This is not a market driven by speculation but by solid and sustainable fundamentals.

You can see in the chart that our corporate price-earnings (P/E) ratios have in fact been trending broadly downwards over the past 10 years despite the strong rise in the market level, and are now between 15 and 16 times annual profit. This is not at all high even if you insist on using the historical standards of value established under those different conditions.

The market P/E ratio would be expected to rise rather than fall if the prevailing conditions were indeed speculative, as people became ready to pay more for earnings. But the recent growth in per-share company earnings has instead outstripped the rise in Australian share prices. This provides a solid defensive cushion against a bear market.

I will go even further. The new investment environment justifies an increase in the market's p/e ratio because of its greater stability and efficiency, and because it yields stronger growth with less inflation.

As investors come to accept that the new regime is irreversible, they should be prepared to pay more for growth '” giving the market yet another positive whammy to the three mentioned earlier.

Another way of looking at valuations is to compare the sharemarket's earnings yield against the present yield of long-dated government bonds. The earnings yield (the reciprocal of the P/E ratio) is market earnings divided by its price, expressed as a percentage. For example, a market P/E ratio of 16 would represent an earnings yield of 6.25 per cent (1/16 x 100). Compared with the 10-year bond yield of 5.1 per cent, that represents sound value for equities, and, by this yardstick, any decline in bond yields would make equities even better value.

What is more, the conservative general expectation of about 10 per cent growth in earnings over the next year, with a slightly slower economy, would give the market an earnings yield of nearly 7 per cent if prices remained the same. This would then provide an even bigger safety margin against the likely future bond yield because inflation and interest rates should fall as growth slows.

Finally, dividends. Australian companies are distributing on average about 60 per cent of net earnings to shareholders and this "payout ratio" trend looks stable. Adjusted for the system of tax-imputation, the market's net dividend yield '” the flow of annual income from a capital investment '” is very competitive with interest income from a government bond on present market prices. And investors should remember that dividends paid by good companies are not only far more stable over time than bond interest; they actually grow as earnings rise.

I conclude that the sharemarket has outflanked the pessimists for most of the past two decades and has routed them over the past two years. This has not been an accident or the result of frivolous speculation.

The huge structural changes in the global and local investment environment have caused a genuine phase shift that justifies radically higher share values. That regime shows no signs of being reversed. And, while risks clearly remain and need to be carefully monitored, they are adequately priced in today's markets.

Australia's sharemarket can rise at least another 15-20 per cent before it begins to look at all speculative in the context of historical valuations. Of course, any market reversals overseas may prevent that advance from happening here '” but Australian shares are likely to be better protected than most international equities in that event. Either way, the prospects for superior performance at home are very encouraging.