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After a substantial rally from the March low, US and Australian markets have recently lost momentum. Naturally, this was just a matter of time: it is untenable that markets could continue to advance at such breakneck speeds indefinitely. The real question, as always, is where to from here? Are we seeing a pause for breath before the next upward push, the beginning of a sustained sideways move or have we all been drawn into a massive sucker rally?
The most fundamental driver of share prices is earnings and although it is common to see perturbations, the relationship between market value and financial performance is extremely well defined, especially over the longer term. This is most often formalised by the Price Earnings Ratio (PE), which has a long term average of approximately 16. As it turns out, this is true of both the US and Australian markets.
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SOURCE: Robert Schiller
In other words, investors have traditionally been prepared to pay a 16 fold premium for a listed company based on its earnings. Invert the calculation (i.e. earnings divided by price) and you can see that investors generally expect listed companies to generate a return of approximately 6.25%pa based on their value.
When presented with this data, it is often tempting to assume that one can quickly and easily determine whether the market is over or under valued simply by comparing the current PE with the long term average, and sadly this is something that is commonly touted by so called experts. If one were to conduct such an analysis we would determine the US market to be overvalued given the current PE average of 20. The Australian market by comparison is currently sitting on an average PE of just 14, inferring it is undervalued.
However this is overly simplistic and ignores the obvious fact that the PE is not only determined by price, but of course also by earnings. So a high PE can be reduced by either a falling price OR rising earnings, or indeed a combination of the two. This means that although the average PE for the Dow Jones is currently sitting at 20 we won’t necessarily see a pull back in price – we could instead see an increase in company earnings, and no doubt that is exactly what the market is expecting.
The other point to note is that although deviations of the PE from the average are always eventually corrected, it can take a long time for this to happen, and great opportunities can be missed in the meantime. If you look at the chart above you can see that the market PE does not sit on the average line for very long, and in some cases has remained well above or below the average for extended periods of time.
For example, you will notice that the market PE crossed above the average line back in February 1991 and did not drop back below it until November 2008, 17 long years later. Over that time the Dow advanced by over 270%. Despite the relative overvaluation of the market during this period, fantastic gains were quite obviously made.
Yet another complication is that the market is always looking forward. That is, we don’t value stocks according to how they are performing now, but rather how we expect them to perform in the future. Investors will quite happily buy a stock with a PE of 3000 so long as they are convinced that earnings will grow significantly and rapidly. As a matter of fact, Yahoo was trading with a PE of just that at the height of the dot com bubble, and while that seems laughable to us today, it was a perfectly rational thing to do based on expectations at the time. So it is important to understand that the market PE is not an infallible valuation measure, rather it is in essence a gauge of market sentiment: high PE’s suggest optimism towards the future, whereas low PE’s signal pessimism.
So where does this leave us? Can we actually deduce anything by studying current market valuations? I believe we can, so long as we acknowledge the limitations of the PE avoid the trap of trying to infer specifics. As Keynes said, it is better to be generally right than specifically wrong.
The fact the Dow has an average PE of 20 suggests that the market is, on balance, reasonably upbeat about future earnings. For further significant gains to be made we will need to see a further significant improvement in earnings expectations. I believe this is unlikely over the next few months primarily because the market will need to see validation of its current expectations, especially given the endemic uncertainty that has persisted since the market first turned back in March. That means we will need to wait until the next major round of corporate results and outlooks. If the next reporting season fails to meet expectations, and importantly if company outlooks fail to inspire, we will most likely see the market pull back. After all, price will be the only variable left to adjust once the earnings component becomes more certain.
The current valuation of the ASX suggests that investors down under are more cautious over future earnings. Nevertheless, there appears to be more upside potential than there is for our North American cousins as any improvement in earnings has yet to be priced in. Of course, although earnings expectations are seemingly more moderate, they can still nevertheless fail to be met. Furthermore, the Aussie markets correlation to the US means that weakness on Wall Street will add considerable downward pressure to the ASX, despite its more attractive valuation.
So ultimately it all comes back to whether or not the expectations of the market are proved correct. If corporate earnings match or exceed current expectations, and company guidance points to further recovery, then almost certainly we will see the market climb higher. If however this isn’t the case, it would be best to sit on the sidelines for the time being, at least until the outlook clarifies somewhat. The position you take in the market ultimately comes back to what you believe is most likely.
The final point to make of course is that within any market there is a wide range of valuations for individual stocks (presently the ASX 200 has a range of PE’s between -7385 and 3937). Gone is the time where broad based gains are the norm: we are now firmly in a stock pickers market. Just ensure that you understand that high PE stocks already have a lot of high expectation already priced in, and that low PE stocks may well be low for a reason (i.e. the outlook is not very attractive). The art is to find stocks where there is an apparent disconnect between reasonable earnings expectations and price. It is this skill that defines a successful investor.
Make the markets work for you!
Andrew Page
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