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Is the ASX overvalued? It’s all in the numbers

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By David Bassanese
 
Just when local investors could be forgiven in thinking all hope was lost, the Australian S&P/ASX 200 share market index has made a feisty lunge to 6,000 points in recent weeks.  It naturally raises the question, can these share market gains be sustained and could the market keep moving higher?

I think it can, but don’t expect runaway gains. And I still suspect our market is likely to underperform our global peers – especially technology heavy indices such as America’s NASDAQ-100 Index.

Of course, some have been quick to point out that the local market’s valuation is now elevated and we don’t have much earnings support underpinning recent gains.

As regards valuations, I’ve got news for them – most markets around the world are trading at “above average” price to earnings ratios. We are not alone.  But comparing current PE levels to history is a little misleading if the fact that global interest rates also remain well below average is ignored.

It’s like saying Australian house prices are overvalued because today’s rental yields are lower than average – but this is to be expected given the structural decline in interest rates over recent decades. The yield return on competing assets – such as term deposits and corporate bonds – has declined, so the yield on both property and shares must also decline. And the way that’s achieved is by pushing up valuations relatively to underlying earnings and rents.

Let’s put some flesh on the bones with some real numbers.  According to my estimates, with the S&P/ASX 200 trading at around 6000 points, it’s consistent with trading on a price-to-forward earnings ratio of 16.2.  Its longer-run average (which I estimate since 2003) is around 14.

So far so bad. It implies the market is 11% “overvalued”.

But today’s yield on Australian Government 10-year bonds is around 2.6%.  Its long-run average is around 4.5%, or a full 2 percentage points less.  That has to be of some relevance to the market.

In fact, if we invert the PE ratio we get what’s called the equity market’s “forward earnings yield”, which is now just around 6.2%. Subtract the 10-year bond yield of 2.6% and we get what’s called the equity premium of 3.6%.

This premium’s long-run average (i.e. since around 2003) has been 2.5% - so the premium remains higher than its long-run average. On that basis alone, it’s hard to argue the market is overvalued.

That said, if we examine even longer-run history we find the market’s equity premium has not tended to be constant over time – rather it has been higher when bond yields have been low and lower when bonds yields are high. In a sense, equity valuations don’t tend to fully adjust to reflect very low and very high bond yields – as the market suspects this level of yields is not sustainable.

As seen in the chart below, my own long-run calculations (based on patched-together estimates of earnings and valuations stretching back to the early 1970s) suggest the market is today reasonably close to fair-value.  With bond yields around 2.5% or so, a PE level of around 16 seems reasonable.

Of course, that does mean should bond yields rise from here, it should place downward pressure on equity valuations. But provided the rise in bond yields is fairly modest (which seems most likely given persistent low inflation), the downward pressure on valuations should not be too great.

By my estimates, a lift in 10-year bonds yields to 3% and 3.5% would push PE fair value down to 15.8 and 15.4 respectively – or lower prices by around 2 to 5%. Note yields at this level would still be consistent with a PE ratio that remains comfortably above its recent long-run average of 14.

And offsetting this of course should be at least a modest lift in corporate earnings, which have been sluggish for some time – plus a not to be forgotten 4% gain from dividends (plus franking credits).

Published: Wednesday, November 08, 2017


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