Sharemarket a bargain by historical standards

In 87 months there has been no capital gain for equity investors despite the domestic economy's stunning effort to avoid a recession.

Companies have managed to grow earnings during this period but investors have shown no stomach for risk and gradually reduced what they are prepared to pay for those earnings. That is what happens in bear markets as sentiment and confidence evaporate.

It makes most of us think: how do we get out of this hell hole? But it should also prompt the question: is the Australian sharemarket now cheap?

There are two standard valuation parameters used to measure whether a market is cheap. The first is the price to earnings ratio (PE) of the market.

The long-term PE average in Australia is just below 15 times future earnings. In other words, investors have been willing to pay 15 times the current-year earnings to hold stocks.

The average, though, can be highly deceiving given that during the period from the early 1970s to the mid-1980s investors refused to pay more than about 10 times current-year earnings, while in the late 1960s, 1987 and in the three years leading up to 2007, they were extremely bullish and happy to pony up closer to 20 times earnings.

At present, investors are paying a modest 12 times current-year earnings, indicating the overall market is cheap. This may be true, but like all aspects of life, things are a little more complicated than that.

What investors are willing to pay depends on various factors, but the central consideration is what earnings per share growth can be achieved in the coming years.

The Australian market has just completed its half-yearly results for the 2012 financial year and, despite meek expectations, it was generally disappointing. At the start of the 2012 financial year, company analysts were forecasting that EPS for the overall market would grow a solid 9 per cent. As the year has progressed, this has been wound back and now the expectation is for an anaemic 3 per cent growth.

This process of winding down EPS forecasts has been in train on a yearly basis since 2008 as heightened expectations have been continually dashed. If investors priced in only 3 per cent EPS growth forever, the current PE multiple would virtually halve given that the long-term average is for about 7 per cent EPS growth.

What is more disconcerting to investors is the 13 per cent EPS growth forecast for the 2013 financial year. This seems exceedingly bullish, especially if the Reserve Bank holds firm on not cutting official interest rates and the big banks tighten their lending policies. The 13 per cent figure would also need the mining companies to bounce back from a poor year. This primarily depends on what happens in China. If demand for resources firms from the Middle Kingdom, then the resources sector, which represents 25 per cent of the Australia market, could carry the day.

However, even after 10 years of thoroughly examining the machinations of the Chinese economy, hardly anyone has a firm grip on how it works and what the policymakers are thinking.

If investors saw the RBA cut rates and the Chinese demand for resources escalate, the PE investors are willing to pay for the market would start to rise and head back over the long-term average of 15 times as EPS growth forecasts dial up.

The second methodology of determining if a market is cheap is measuring the yield provided by equities compared with their great investment rival, bonds. A quick look at this scenario shows equities in Australia are cheap to the tune of about 30 per cent.

This is far more encouraging and the main argument used by bulls who are quick to claim that the yield on many stocks in Australia makes it compelling to buy equities rather than the paltry return delivered by bonds and cash.

The counter-argument to this thesis is that equities markets are cheap all over the world compared with bond markets and have been for some time.

The 30-year bull market in bonds, where prices rise and yields fall, is nearing completion and we shouldn't get carried away with this. In the not-too-distant future the yield on bonds both here and abroad will climb and the gap between bond and equity valuations will narrow. Unfortunately, many investors have been saying this for the best part of a decade and they have been wrong.

What can we conclude from this analysis? There is no doubt that the Australian sharemarket is cheap both on a historical and relative investment basis. This is comforting because it should limit the downside to the market's performance in the coming years.

What is less certain is what will be the trigger for equities to start to reflect their true value and when it will happen. One thing for certain is that 3 per cent EPS growth won't cut it in the future and instead of downgrading forecasts each year we need to return to an upgrading cycle.

Matthew Kidman is a director of WAM Capital and a former fund manager.

What investors are willing to pay depends on various factors, but the central consideration is what earnings per share (EPS) growth can be achieved in the coming years.