THE Australian sharemarket is at present trading at the same level as it was in December 2004.
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.
Frequently Asked Questions about this Article…
Is the Australian sharemarket cheap right now?
Based on the article, the Australian sharemarket looks cheap by two common measures: the market PE is around 12 times current-year earnings (below the long-term average of just under 15), and equities yield about 30% more than bonds. Both indicators suggest the market is inexpensive relative to history and to bond markets.
How should everyday investors interpret the market price-to-earnings (PE) ratio?
The PE ratio measures how much investors are willing to pay for each dollar of earnings. The article notes Australia’s long-term PE averages just below 15 times future earnings, current readings are about 12 times, and historical ranges have been roughly 10 times in weaker eras and closer to 20 in very bullish periods. A lower PE can signal cheapness, but it also depends on expected future EPS growth.
What are the recent earnings per share (EPS) growth expectations for the market and why do they matter?
Analysts began the 2012 financial year expecting about 9% market EPS growth, but forecasts were cut to roughly 3% as results disappointed. For 2013, forecasts of 13% EPS growth exist but the article calls that optimistic. EPS growth expectations are central because the PE investors will pay depends heavily on how much earnings per share are expected to grow.
How much does the resources sector affect the Australian market’s outlook?
The resources sector represents about 25% of the Australian market in the article. A rebound in mining companies would significantly lift overall market EPS, so future demand for resources—especially from China—is a key variable for a stronger market performance.
Could a Reserve Bank (RBA) interest rate cut or bank lending changes trigger a market recovery?
Yes. The article suggests that if the RBA cuts official interest rates and big banks ease lending, investors may become more willing to pay higher PE multiples. Such policy moves, combined with improving EPS forecasts, could help equities re-rate toward the long-term average.
Why compare equities yields to bond yields, and what does that comparison show?
Comparing equity yield to bond yields helps investors decide whether stocks look more attractive than fixed income. The article finds equities are about 30% cheaper than bonds by this measure, which is a bullish argument for buying stocks. However, it also warns bond yields may rise in future, narrowing that gap.
Does the article say the market’s downside is limited?
Yes. Because the market is cheap both historically and relative to bonds, the article argues this should limit the potential downside in coming years. The bigger uncertainty is what will trigger a meaningful re-rating to reflect true value.
Who wrote the article and what perspective do they bring for investors?
The article is written by Matthew Kidman, a director of WAM Capital and a former fund manager. He emphasizes valuation measures (PE and yield comparisons), EPS growth forecasts, and macro drivers like RBA policy and Chinese demand as keys for everyday investors to watch.
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