The Price Is Right

Is the market overpriced? It's the most important question on investors’ minds as we head into the notoriously volatile final quarter of the calendar year on the ASX. With the media trumpeting new “records” on the sharemarket every other day and price earnings (p/e) multiples on the ASX actually rising beyond the average levels of overseas stockmarkets, the question is highly relevant.

Moreover, for most people the question sparks a frisson of fear. If there is a “reversion to the mean”, we will have to fall back into line with our traditional discount to the rest the world. For most of the 1990s Australian shares traded at a 20% discount to the rest of the world; today the rest of the world is trading at 14.5 times next year's earnings, according to UBS, and we are trading at 14.7 times.

We must be heading for a fall, or so the theory goes.

At Eureka Report, we don't subscribe to that theory. First, there's no unbreakable law that says market averages must return to any “mean”. Some time ago I met Australia's most celebrated economic historian Geoffrey Blainey (who also pops up in Alan Kohler's interview with fund manager Julian Mitchell today). I asked Blainey what he thought of the fundamental notion that markets must return to their long-term average levels for fair value to prevail. He threw that notion out the window: He said long-term averages mean very little when set against any market; he also said there is no reason in a progressive society why markets should revert to any historical benchmark.

Second, what's so scary about the ASX breaking new records? If it never broke new records we'd never make any progress. Time moves on. The 2006 business diaries are already in the shops; in other words, it is a long time since global markets began their extended slide with the initial decline of the NASDAQ in April 2000.

Of course, what investors really want know is what will happen next? Where does our well-priced market go from here. In today's edition we publish three views on the outlook for the market, at three points in the spectrum. Our very bullish stockmarket correspondent, Charlie Aitken, says the market could become 10–20% more expensive than the United States before local investors would start switching to foreign markets. Fund manager Julian Mitchell takes a pragmatic view of the market, conceding it has become “a little bit expensive”, but he has no plan to switch out of ASX stocks, suggesting they represent the best value in any asset class at present. Meanwhile, a report from UBS '” one of the most powerful stockbroking firms in the local market '” implies current prices are not sustainable. UBS strategist David Cassidy says our historic earnings performance cannot justify current premiums and that sustained outperformance is unlikely.

Not everyone is as bullish as Charlie Aitken, but he sets out some powerful reasons why Australian shares deserve their current prices, including the growing power of monopolies or near-monopolies such as ABC Learning Centres, Amcor, AWB (that's just the ones beginning with the letter 'A') and oligopilies such as the banks, media and transport companies that are world class investments.

Charlie might also have mentioned the increasing proportion of foreign earnings from Australian companies. A brief glance at the table below shows the high level of foreign earnings at some of our bigger companies.

In a few month's time you can add Orica to that list, as this week's Dyno Nobel deal makes it one of the world's dominant mining services companies.

Don't forget that apart from picking up most of these companies on a reasonable multiple in local currency, the Australian investor also enjoys the wonders of franked dividends. Putting these advantages together, it's little wonder Australian investors have held back from switching to overseas shares.

The offshore earnings growth of ASX listed companies is one of the most important changes for Australian share investors since the 1990s. Australian stocks are becoming “internationalised” and this is definitely being reflected in higher price/earnings multiples. It does not fully explain why we are now on a par with international markets, but it goes some way to doing so.

In contrast to our bullish view, one of the dominant technical arguments among bearish investors at the moment is that Australian shares are even more overpriced when assessed on a sectoral basis. UBS actually reweighted the Australian market in an attempt to strip out the exceptional nature of Australian trading conditions. On this basis, UBS concluded that the sector mix in Australia '” with 48% of the market devoted to banks compared to 23% in the rest of the world '” meant that on a rest of the world “weighted” basis, we are actually trading on a p/e of 17.6 '” reflecting a substantial premium of 21%.

But really, folks, it seems these people are looking for something to worry about. Back in the real world, it's interesting that the listed company Australian Stock Exchange Ltd '” surely a very good proxy for Australian shares '” trades at a 10% premium to its global peers. A Macquarie Bank report shows that from a basket of 10 listed stock exchanges around the world, the ASX Ltd is selling on a forward multiple of 20.1, a figure only exceed by the 30.1 forward p/e for NASDAQ in New York.

Just to put it all in perspective, the level of premium in Australian shares compared to overseas markets is very slight indeed. In fact, the non-weighted premium to the rest of the world is only 1%.

What's more, it does not require a drop in value of Australian shares for the balance to change again. The US markets '” representing more than half of the total weighting in any rest of the world calculation '” have been in the doldrums for almost five years. American and overseas markets could return to trading at a premium to Australian shares if they recover strongly. This outcome would not mean a drop in Australian share prices; rather it would signal a solid year on the ASX against a better year on Wall Street. If that's the risk, most Australian investors will take it.