Summary: Investors may be worried that Australian assets are overvalued. But considering the price/earnings ratio of different asset classes provides insight into whether or not valuations are stretched. The results are not strictly comparable as some are gross and others are net, but results do show whether an asset is overvalued or undervalued compared to its historic norm.
Key take-out: On pure price/earnings valuations, residential property and fixed interest bonds are extremely overvalued, commercial property is overvalued and shares as a whole look fairly valued.
Key beneficiaries: General investors. Category: Economics and investment strategy.
A big concern for investors is that every Australian asset class is overvalued. Is that so?
The most common way of valuing any asset is its price/earnings ratio. In other words, the amount you have to pay for it as a multiple of its annual earnings. For instance, if you bought an investment property, how many years of rent would it take to recover what you paid for it? Or if you bought a share, how many years of earnings would equal its price?
The following charts attempt to value Australian assets on that basis. Because their metrics vary they are not strictly comparable. For instance, residential rent is on a gross basis (i.e. before expenses) whereas share earnings are net of expenses. But they do show whether an asset is overvalued or undervalued relative to its historic norm.
So here’s a roll-call of present Australian asset class valuations starting with residential property.
Our first chart shows the Australian house price index compared with America’s. Notice how home prices after ranging for 90 years took off in the 1970s and reached stratospheric heights after 2000.
For housing the rent to price ratio is the most widely accepted valuation tool. As you can see in the next chart, housing in is now extremely overvalued compared to its historic benchmark. Other housing valuation ratios such as price to disposable income and price to the CPI index reinforce this conclusion. Indeed the Bank for International Settlements (BIS) says Australia’s residential property market is the most overvalued in the world after Norway.
Melbourne’s property market looks particularly vulnerable – see next table which is for the June quarter of 2014. The last time residential property was a steal was 1980-1987 when a lot of baby boomers bought their first home.
Next is a chart on commercial property as covered by the S&P/ASX A-REIT index. It covers shopping malls, offices, factories, warehouses and pre-schools that are owned by listed property trusts. As can be seen, the A-REIT’s price index has been recovering from its 80% crash between February 2007 and March 2009.
A-REITs’ distributions usually represent their earnings (because trusts cannot withhold profits). As shown in the next chart, their dividend yield at 5.18% is the lowest it’s been in seven years. This suggests a price/earnings ratio of 19.3 (obtained by dividing 100% by 5.18%); the highest it has been since 2007 after which A-REITs crashed.
I am not suggesting a repeat outcome because A-REITs have halved their debt since then, but their present valuation looks stretched especially if interest rates were to rise. Also several are now paying more in distributions than they are earning (see A-REITs: Bad habits are back).
Source: PIR Market Data August 2014
The next chart shows by how much the trading value (i.e. capitalisation) of the A-REIT sector overstates or understates its underlying net tangible property values. In other words, has the share market put a higher or lower price on A-REITs than the property values that underpin them?
Here too the story is one of overvaluation. At present A-REITs are about 26% above their net tangible asset value, though those A-REITs without a development or funds management arm (shown as excluding staples) are only about 8% overvalued. The time to have bought A-REITs was two to five years ago.
Source: PIR Market Data August 2014
Centuria, an unlisted property syndicator, summed up the commercial property situation in its September Property Focus bulletin:
The busy start to 2014 in direct real estate markets has continued into the second half of the year, with a weight of domestic and international capital chasing a finite pool of assets.
Although the amount of stock on the market has increased to levels not seen for a number of years, buying assets at attractive prices remains difficult as buyers compete for stock and drive prices up, despite the softness in terms of underlying occupier fundamentals in many markets.
Property syndicates offered high returns before 2014 because typically cap rates (the net operating income of a property expressed as a percentage yield on its current market value) exceeded 7% while borrowing costs were under 5%. Cap rates have subsequently compressed.
Next comes the share market overall. As can be seen the ASX has participated in the global stock market gyrations of the last twenty years though it felt less of the dot.com price bubble and bust of 2000 because its technology sector was small. Note also that Australia has underperformed during the last two decades, especially against the USA.
Our strongest sectors have been resources and finance which also happen to dominate our stock exchange. Question markets now hang over resources (because of falling commodity prices in response to a faltering Chinese property market) and finance (because our banks on price earnings ratios are the most overvalued in the world).
But overall our share market is not excessively overstretched on price/earnings ratios. As can be seen in the next chart, Australia’s stock market trailing price-earnings ratio at 17 is only slightly above its long term average of 15.
And the forward price/earnings ratio at 14 is fractionally below the historic average.
Also using purely technical analysis, the Australian All Ordinaries index is hugging its historic trend line whereas the American S&P 500 index is well off mark.
The best time to have bought shares was March 2009 when my Active and Conservative strategies issued buy signals. Since then the Australian share market has rallied, but on both fundamental and technical grounds it has not over-reached itself.
Finally, how do bonds rate? Here the price/earnings ratio is the equivalent of the interest yield reversed. So for instance an Australian government ten year bond which currently earns 2.9% has a price/earnings ratio of 34.5.
Australian bonds ranging from gold plated triple-A government securities to junk status triple-B corporates are at historic low yields, though the chart below shows only the last sixteen years. What this means is that their price/earnings valuations are the most overstretched on record. The prime time to have bought bonds was early 2008 with a second bite of the cherry in 2010.
On pure price/earnings valuations, residential property and fixed interest bonds are extremely overvalued, commercial property is overvalued (though the unstapled sort less so) while shares as a whole look fairly valued (slightly overvalued on historic earnings, but slightly undervalued on forward earnings).
It’s reassuring to know that the Australian share market is fairly valued on fundamentals, though disconcerting that property and bonds (the major alternative investment classes) are significantly overvalued.
Percy Allan is a director of MarketTiming.com.au For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds, see www.markettiming.com.au.