It’s been a depressingly long eight years since the value of listed Australian companies peaked in November 2007, when the popular S&P/ASX200 index reached 6800. At its current level of about 5,000, values are down 25 per cent and you’ll need a 33 per cent price gain to get back to that reference point. If it wasn’t for eight years of generous dividends, retirees would be starving. Let me explain why we are where we are and what it takes for a return to Bruce Springsteen’s Glory Days for the Australian share market.
Our earnings recession
Despite media and expert prognostication, it’s corporate earnings that drive the share market and your local equity returns. While investors and speculators pay a fluctuating, greedily high or fearfully low multiple of these earnings, that only affects short-term prices. Over the long term, the growth in value of the companies in your portfolio equals the growth in their per share profits. Your investment return is simply this, plus dividends. As I pointed out earlier (see A pointer to high returns, 29 August 2012), the long run pre-tax return of Australian shares has been a little over 11.5 per cent annually (the exact number depends on your starting point), driven by 6.5 per cent average annual growth in listed company profits plus 5 per cent from profits paid out each year as dividends.
The reason the Australian share market is so far below its peak value is sadly because so too are Australian corporate profits. Figure 1 shows the change in analyst estimates of Australian and US company earnings per share over the last 10 years, including what they expected on 31 December 2015 for the year ahead (when the local index had then finished at 5,300).
Figure 1: Expected earnings of the Australian and US share markets over the last 10 years to December 31 2015 and respective market price index.
Unlike the US, where listed companies are earning 30 per cent more than they did in 2007, Australian company earnings are down 20 per cent. Investors have been suffering through a local earnings recession.
In this figure you can also see superimposed the level of the local share market price index and how it largely tracked earnings – just sometimes optimistically above and sometimes pessimistically below.
To help you understand how feelings of emotion and about risk evolved over this period, Figure 2 plots the multiple of past actual earnings investors paid in Australia – the so called “trailing” P/E. It ranged from a low of nine during the depths of the GFC and 11 when markets worried about governments defaulting on their debts. It reached a peak of just over 17 in 2013, optimistic the worst was over. The two dots show the P/E of the market at December 31 2015 was the same 14.9 as it was at the pre-GFC peak.
Figure 2: All Ordinaries trailing price/earnings ratio for 10 years to December 31 2015. Shown also is the value of the index at different P/E ratios based on recent 2015 earnings. If future earnings will be less, so should these estimates. Source: Professional Wealth
These charts make some important points:
• The share market wasn’t trading at an unusually high P/E multiple before its GFC collapse. That made it much harder to predict. If anything the “E”, or earnings, were unusually high, pumped up by a lot of performance enhancing leverage. The GFC was basically caused by financial institutions tripping over each other while running with scissors.
• Changes in the P/E multiple do not explain the large drop in Australian share prices since 2007. It’s collapsed earnings.
• The market P/E is not cheap and therefore nor are Australian shares. When the market falls below 5,000, it isn’t the screaming bargain you might think it is. The above chart is based on past earnings. If recent falls in commodity prices (including iron ore and oil) drive earnings lower still, then our share market is actually more expensive than shown.
• While low interest rates justify higher P/E multiples and prices (here 15 suggested as normal), high P/E ratios won’t get our market back up to 6,800…only increased profits will. Superimposed on the right side of Figure 2 is what the market index would be based on different P/E multiples. All fall short and these numbers may already be optimistic not factoring in January’s commodity price falls.
• If you can’t handle the index falling below 3,999, then stop investing in equities. This is entirely possible if fear returns of the magnitudes experienced before.
• Country diversification works – if you invested offshore in the US market, you enjoyed 30 per cent earnings-justified price gains coupled with a 30 per cent gain from the collapse in the Australian dollar. No amount of extra franking credits earned locally compares. Caution: US company earnings look to be stalling and are based on record corporate profit margins and debt levels. Don’t count on growth continuing. In December, (see Finding perfect balance in 2016, December 21, 2015) I predicted share prices were vulnerable to a correction. They did and still are. In November, (see The perfect offshore allocation, 18 November 2015) I wondered about reweighting back to Australian shares. I still do.
Why are earnings so bad?
There are two reasons Australian share earnings are so poor:
1. Resource prices have collapsed from their 2008 and repeated 2012 “high”
2. Australian companies have issued an enormous amount of profit diluting shares
Figure 3 shows the change in commodity prices over the last 20 years – the earlier 10 years added to lower expectations of any meaningful recovery. Since peaking in 2008 (remember “peak oil”) and returning to that plateau between 2011 and 2014, prices have fallen off a cliff. Iron ore, which builds the profits of BHP and Rio, has fallen from above $175 to below $50/tonne. Oil and related energy prices which fuel the profits of companies like Woodside and Origin have fallen from $100 a barrel to about $30.
Figure 3: $US commodity prices since 1996 (index 100 = 2005) and percentage that Australian price-taking resource companies make up of total Australian share market value.
To the frustration of many shareholders then, profits were mostly reinvested, building increasing supply. Production volumes have since grown (4x for iron ore for instance), not fallen, so falling profits are a price not a volume problem. What a sad joke the Resource Super Profits Tax looks like now.
When you slash the profits of resource companies that made up one-quarter the value of the Australian share market in late 2007 (and a third in 2012, when bank share prices were on the ropes), then you slash the index value. At December 31 2015, depleted energy, mining and metals companies made up only 16 per cent the value of the Australian share market, and probably now its 15 per cent or less – half what it was two years ago and a third less than what it was in November 2007. The good news is that further falls have much less an impact and probably can see the bottom. Look at the left side of Figure 3 and just don’t feel entitled to a recovery.
The decline in the relative contribution of resource companies to the index from ’96 to ’06 (shown in Figure 3) was mostly due to the rise of Australian mega-banks. Pre-tax bank profits have nearly tripled from $15 billion in 2003 to over $45bn, hence the proportion in the index has grown. What is now worrisome is that the big 4 banks are the biggest 4 stocks in our market and account for most of the ridiculous 48 per cent that financial companies make up of Australian share market value at 31 December 2015 (probably now 50 per cent). Red light. Red light. Red light.
The bank’s contribution to the index has however been restrained following large capital raisings. This theme extends to other sectors including real estate investment trusts, which also raised substantial capital during the GFC. According to the ASX (click here to see details), in 2009 when CFOs’ pants were bunching up around their ankles, capital raisings totalled $109b. That amounted to 8 per cent of the value of the stock market then. In 2015, Australian banks raised even more capital than they did in the GFC.
Assuming capital raisings since 2007 amount to 10-20 per cent of market value, the same aggregate dollar of profit generates only 80-90 cents of earnings per share. That also depresses the index and investors.
What next: The Roaring 20s or Investor Japanisation?
As shown in Figure 4 this earnings recession is getting long in the tooth, second longest in length of the four we have had over the last 50 years.
Figure 4: Fifty years of Australian listed company earnings, shown using a log scale. Shown in red are periods required for earnings to recover to prior peak values.
If the “trend is your friend”, then earnings should recover and catch up to their long term annual growth rate of 6.5 per cent. They generally do this by growing above 10 per cent annually during an earnings boom. Mathematically, the S&P/ASX200 can reach 6,800 if earnings trend sideways for one more year and then grow at 10 per cent annually for three years. This of course would bring us to the start of the 2020s decade. Perhaps a “Roaring 20s” is around the corner for investors?
In order to grow earnings, companies must do one or more of four things: sell more (increase volume) for more (at a higher price) using less (perhaps staff) bought for less (energy perhaps). If you can’t see how Australian companies can do this, especially banks and other financial companies now half the market, then the future ahead could instead look more like the dismal share and bond market returns doled out to Japanese investors since their market peak in the 1990s.
Dr Douglas Turek is principal advisor with independently-owned family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au