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Towards the end of 2007 both the Australian and US share markets were trading at record highs, but as we know both proceeded to halve in value over the following 15 months as investors dumped shares throughout the Global Financial Crisis (GFC). The interesting thing to note is that since these markets hit their nadir in March of 2009, the Australian market has significantly underperformed its US counterpart.
Since the bear market low the US market (as represented by the S&P 500) has rallied by about 85%, compared with just 51% for the Aussie market (represented by the ASX200).
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How do we explain this apparent anomaly, especially when our economy is performing so much better than the embattled US, where unemployment remains close to 10%, retail conditions are weak, and the property market continues to stagnate?
Do dividends account for the difference?
Perhaps the difference can be accounted for, at least in part, by dividends? After all, Australian stocks tend to provide much more generous payments.
Unfortunately the data does not support this theory. If we look at the total return indices (that factor in dividends by reinvesting them along the way) we see that the same period saw the S&P 500 advance by over 93% compared with just 61% for the ASX200. That is something quite remarkable and worth repeating: US stocks, on average, have nearly doubled in value over the past 22 months. It often takes time for perception to catch up with reality, but given the lingering pessimism in the financial press a casual observer could be forgiven for not noticing this.
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What about earnings?
The more obvious suspect is corporate earnings. While share prices are entirely determined by the interaction of buyers and sellers (and hence prone to all the frailties of human subjectivity), they are nonetheless most closely tied to earnings. Investors may be prepared to exchange shares at totally irrational prices from time to time, but over the longer term earnings tend to keep things grounded.
Currently the average trailing price to earnings ratio (PE) of the US market is 18.3. That is, US listed companies are trading at a price that is roughly 18 times the value of last year’s earnings. Compare this with the Australian market where the average PE is 14.3, which is considerably lower.
For the Australian market to reach an equivalent PE to that of the US it would need to rally by a massive 28%. Alternatively, the US market would need to experience a 22% drop for its average PE to be equal to the current Australian average. In essence, either of these events (or a combination of the two) would nullify any of the observed difference we see between Australia and the US. So it may be that the outperformance of Wall Street is simply a consequence of investors’ willingness to pay higher premiums for US stocks.
Case closed..?
Before we close the book on this one, and simply ascribe the difference in market performance to American exuberance, we must remember that the market is always pricing shares based on future expectation, not past performance. While the difference in PE ratios appears higher when using historical earnings, the difference in valuations could be justified by greater expectations for future earnings growth in the US. And indeed this appears to explain at least some of the observed difference.
The forward PE of the Australian market (which uses forecast earnings instead of historical values) is currently 12.2, compared with 13.7 for the American market. So the valuation gap is at least partly narrowed by expectations for a greater improvement in US earnings in the coming year.
Nevertheless, both a price and valuation gap remains. The Australian market would need to rally by around 13% to reach an equivalent forward PE ratio to that of the US.
False assumptions
Of course the relative underperformance of the Australian market appears anomalous only if you make the flawed assumption, as many do, that both markets must perform in tandem. The obvious thing to keep in mind is that these are totally different markets, comprised of different companies, operating in different economies, in different regions of the world. Why should we assume that the Australian market should perform the exact same as another equity market on the other side of the world? Yes we live in an ever more integrated global economy, and yes the US is a major influence on the world stage, but the two markets are nevertheless distinct entities.
The myth that our market is destined to follow the US is reinforced by the day to day action of our market. Certainly it is more likely than not that Australian share prices will rise after a good session on Wall Street, but quite often the magnitude of the move is considerably different, if indeed the general direction is the same at all. A picture is worth a thousand words; below is the US and Australian Markets over the past 10 years:
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Since 2001, the Australian market has climbed 45% versus a 4% drop from US equities. If we again factor in dividends the contrast becomes even starker, with the Aussie market advancing 121% compared with just 17% for the US on a total return basis.
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We can do this exercise over many different periods and we will often see a significant divergence of performance, even though both trajectories will usually show a superficial resemblance.
Hence it seems as though we have discovered a more simple explanation for the recent disparity in market performance: comparisons of relative performance are entirely context dependent. Put simply, selectively choosing agreeable time frames will allow you to justify any argument. Yes, the Australian market has underperformed the US since March of 2009, but simply by encompassing a longer period we can completely turn the tables.
So what?
The lesson here is straightforward. Don't mistake the recent divergence of US and Australian markets as evidence for either an undervalued local bourse or an overvalued US market. Each market is a unique and distinct entity, and there is no evidence to suggest that they are destined to experience the same performance over any given period. Certainly comparisons between markets can influence investor psychology to some extent but there are far more influential factors at play.
Of course, even if you believe that these two markets should ‘equalise’, the apparent divergence could just as easily be corrected by changes in relative valuations through differing earnings performance: prices (and hence index levels) are only half the story. As always, it is far more important to take the time to understand the specific businesses that underlie the broader market indices. They are after all the foundation on which everything rests.
Make the markets work for you!
Andrew Page
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