Prices are getting ahead of earnings

Market metrics suggest that earnings need to play catch-up to recent share price gains.

The popular valuation metric, the price earnings ratio of the Australian market excluding the resource sector, comes in at 11 per cent above the 20-year trend. From this, we can take away this portion of the market looks expensive relative to historic valuations.

There have been suggestions equity markets could be in bubble territory, but Melbourne-based Franklin Templeton Investments portfolio manager  Peter Wilmshurst was quick to dismiss this notion and counter with the prospect that some stocks could be overvalued, which is perhaps a realistic reflection of investor exuberance.  

Much of the recent gains of the market in general have been driven by price earnings expansion – investors willing to pay more for each dollar of earnings as opposed to an underlying increase in earnings per share, supported by improving economic conditions among other things.

With domestic interest rates at 2.5 per cent and the feeling they will remain lower for some time yet; investors have been enticed to pay more for earnings with the prospect of a dividend yield higher than anything else available. The current unfranked dividend yield of the Australian market comes in at 4.6 per cent.

Beyond low interest rates has been the ability for companies outside of the mining sector to continue to deliver consistent returns. Although economic conditions have not been shoot the lights out good, they have been relatively smooth and consistent, allowing for companies to plan based on expectations, without too much variance. This has meant cost cutting programs have helped profitability margins and boosted earnings per share, despite revenue not necessarily growing at the same rate.

The latest round of business confidence survey results confirm the outlook is more positive, but underlying business conditions still remain soft. Recent earnings reports from the US highlight that companies can still post desirable profit figures even when economic conditions suggest this should be a difficult task.

As the ASX basks in the glory of a fresh five-year high, it’s time to start thinking about where the market can go from here. It doesn't look like earnings are going to be driver of any further market gains.

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