Oliver's Insights

KEY POINTS

• Despite rising to near the 5000 level, Australian shares are not in a bubble. The market is not overvalued and investors are not yet euphoric.
• However, there is a risk a bubble may develop.
• We see more upside for local shares.

With the Australian sharemarket pushing to near the 5000-point level a month ago before undergoing a modest correction, it is reasonable to ask questions about its sustainability. After all, it was only just over a year ago that we first went through 4000 points. Are shares overvalued? Is there a bubble? How far could it go?

The last time we looked at these issues in detail was in September last year; we concluded that the Australian sharemarket was not then in a bubble, but that there was certainly a risk that a bubble may form. Now with the market even higher, it is reasonable to review the issue again. Our assessment is little changed.

Are Australian shares in a bubble? Sharemarket bubbles are marked by overvaluation, extremely positive investor interest, a high level of capital raising and a narrowing in sharemarket strength. Although there has been some deterioration in terms of the latter, there is no sign of a bubble in terms of the first three, so our overall assessment remains that Australian shares are not in a bubble. First, local shares are still cheap. Our analysis shows shares remain at the low end of their fair value range, with fair value being around 5500.

AUSTRALIAN SHARES ARE STILL NOT EXPENSIVE

The main reason for this is that since 2001 share prices have lagged behind profits. For example, over the past two years the sharemarket has risen 45% but earnings per share have risen 47%. Through 2005, the market rose 17.6% but earnings per share rose by about 22%, based on results for the December-half reporting season. This contrasts with what happened in 1987, when shares jumped 90% in the 12 months to their peak, but earnings growth was 25%.

AUSTRALIAN SHARES '” SCRAMBLING TO CATCH UP WITH PROFITS

The Australian sharemarket’s high dividend yield also underpins the market’s attractive valuation. The dividend yield grossed up for franking credits is only just below the 10-year bond yield and is well above the yield on rental housing. Stronger-than-expected dividend growth was a key feature of the December-half reporting season.

THE YIELD ON AUSTRALIAN SHARES REMAINS ATTRACTIVE

At 14.5 times, the price/earnings (P/E) multiple (calculated using 12 months ahead forward earnings) is still just below its 10-year average of 15.1 times. It is also well below its late 1990s high of 18.3 times.

Some have argued that Australian shares are now expensive compared with global shares because they are trading at a similar forward P/E to global shares, whereas they were at a discount in the 1990s. It should be noted, though, that the 1990s is not a great point of comparison because Australian shares were priced at a discount then, reflecting the aftermath of the corporate scandals of the late 1980s, Australia’s high inflation track record and because they missed out on the IT bubble. With Australian shares over the past decade generating better earnings growth than global shares '” despite paying out a higher proportion of earnings as dividends and with lower risk '” there is no reason Australian shares should be trading at a discount.

Second, although investor confidence in Australian shares is up, we haven’t seen the euphoria that usually accompanies bubbles. The proportion of consumers nominating shares as the wisest place for savings is well below peak 2000 levels. Inflows to equity funds are running at solid but not boom time levels. Foreign investors appear to remain underweight Australian shares.

AUSTRALIANS ARE STILL NOT EUPHORIC ABOUT SHARES

Third, net equity raisings have picked up, but relative to market capitalization, capital-raising is not excessive as is usually the case in sharemarket bubbles. Finally, while signs of a narrowing in sharemarket strength suggest we may be entering a bubble phase, this conclusion is ambiguous. The final stages of share bubbles are often characterised by a narrowing in investor interest to a few sectors or stocks. Over the past year we have certainly seen this with resources shares. But the normal outworking of this during a bubble '” that is, a big widening in valuations '” is still not yet evident. The chart below shows the spread between the top 25% of shares, less the bottom 25% of shares in terms of P/Es. Market bubbles see a widening in P/E dispersion, with some shares trading on exorbitant P/Es (technology shares in the 1990s, for example) and others on very low P/Es. So far this is not the case.

P/E DISPERSION REMAINS LOW

Low P/E dispersion means that it is hard to find stocks that have been overlooked in favour of others, which partly explains the refrain of value managers over the past few years that it is “hard to find value in the market”.

Over the past six years, Australian shares have outperformed global shares and made record highs '”global shares are still below their previous year 2000 highs. This has led some to claim the Australian market is ahead of itself and due for a reversal. It isn’t that simple. Over the past 25 years, Australian and global shares have had similar capital gains. As indicated below, the outperformance by Australian shares (in local currency terms) over the past six years is really just a catch-up to their underperformance in the 1990s, when global shares experienced the IT bubble. This is far from suggesting they are about to underperform. The problem has been with global shares and the IT bubble that engulfed them in the late 1990s, not Australian shares.

AUSTRALIAN SHARES ARE NOT OUT OF LINE RELATIVE TO GLOBAL SHARES
So could a bubble be developing? The Australian sharemarket is not in a bubble, we continue to see the “risk” of one developing as being high.

'¢ The swing from IT stocks (the centre of the last bubble) to “old economy” shares, such as resources and higher yielding shares that have a high weighting in the Australian market, may have further to run.

'¢ The rise of China is adding to this by providing a positive displacement, which is clearly supportive for Australian resource stocks.

'¢ Low yields on alternative assets are attracting investors into shares.

These considerations could easily see local shares pushed much higher. Obviously, there is no clear answer as to how high it could go. But if the market were to rise to the past peak in the forward P/E in 1999 (18.3 times), this would imply a rise to about 6100 for the ASX200 (without assuming any change in forward earnings). Note: This estimate will move up as earnings rise.

CONCLUSION

Our assessment remains that Australian shares are not in a bubble. Valuations remain reasonable, investors are not euphoric and while there has been some deterioration in the breadth of share market participation this is not evident in relative valuations between sectors. However, there is a “risk” that a bubble may develop and it is likely to become an increasingly volatile ride for investors. Either way we see further gains in Australian shares this year.