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No the Market Isn't Overheating - Eureka Report Article

February 5, 2007
No, the market isn't overheating
By Scott Francis

PORTFOLIO POINT: Investors have no need to worry about market valuations, and should relax and ignore the market noise.

The start of any new year evokes speculation about what it has in store. For investors, part of that focus is on equity markets and, after three years of significantly above-average (20%-plus) returns, they are asking when the party will end.

One of the most important ways to evaluate any market is to study the performance of the price/earnings (P/E) multiple: if the P/Es are normal the market should be trading at or near fair value; if they are out of line with historical patterns there could be cause for concern.

To put the Australian market in perspective, I have examined research and comments from Jeremy Siegel, professor of finance from the Wharton Business School and author of the book Stocks for the Long Run. He proposes useful valuation criteria for sharemarkets. His comments are drawn from an academic paper that looks at historical market returns, and from his current market commentary.

His ideas are particularly relevant to Eureka Report readers, who would have noted Charlie Aitken's comments on Friday, Brace for a little pain, about the homogeneous worldwide market. Aitken pointed out that the Australian and US markets are trading almost in tandem, with P/Es of about 15.

Long-run market valuations

Siegel's paper The Shrinking Equity Risk Premium, published in the Journal of Portfolio Management in 1999, looks at long-term sharemarket data to make conclusions about future returns based on the P/E multiples of markets.

The paper examines US sharemarket returns from 1802 to 1998, a period of nearly 200 years, and finds that the after-inflation returns from investing in shares over this period is 7.0% a year. Interesting for us in Australia, Siegel noted that long-run returns from world sharemarkets were similar to US sharemarket returns.

Siegel's formula for anticipating post-inflation sharemarket returns is relatively simple: the earnings yield equals the expected after-inflation return. (Earnings yield is the opposite of the P/E multiple: instead of dividing price by earnings, you divide earnings by price to get a percentage figure for earnings yield. The ASX earnings yield at present is about 6.75%).

To calculate earnings yield yourself from a P/E, simply divide one by the P/E ? a P/E of 15 equates to an earnings yield of one divided by 15, giving one-15th or 6.7%).

With this earnings yield of 6.75%, and therefore an expected after-inflation return of 6.75%, Australian shares seem to be very close to the Siegel's long-term after inflation "normal" return of 7%.

I want to make quick reference to a letter Siegel wrote to the editor of the Wall Street Journal in April 1998. He was referring to equity market valuations at the time, and said: "Capital theory predicts that the 7% real (after inflation) return of stocks should be equal to the average earnings yield on shares . around 14-15 (P/E) over long periods of time. The S&P Stock Index is now selling at near 25 times projected earnings, an earnings yield of only 4%." As was shown in the following three or four years, his concern over valuations in the US was well founded, an example of Siegel's theoretical work being applied in a practical context.

A more recent comment from late last year, in an article published on his website, Siegel says: "No one knows what the future will bring . I think the odds favour continued economic expansion and if this turns out to be the case, stocks will no doubt be your best investment." It is a comment more directed at the US situation, but one not completely irrelevant for Australia given the similarities in valuation we currently enjoy.

So where do we stand?

To get a better idea of Australia's P/E history, the Reserve Bank of Australia's website offers some very useful data back to the early 1980s on index levels, dividend yields and P/E multiples.

The data shows the Australian market traded above a P/E of 20 from April 1997 through to December 2003, during which many other world markets, including the US, also traded at high P/Es.

More typically, taking the stats from December 1982 ? which is where the RBA starts its P/E and dividend yield statistics ? the average monthly P/E for the market has been 18.7 and the average yield 4.03%. I would be cautious about considering this 25 years of data as being "long term", as it has come during a time of:
  • Generally falling interest rates.
  • Generally low inflation.
  • Above-average growth in corporate earnings.

The current market statistics (December 2006) are set out in the following graph, with the current market dividend yield being 3.73% against the average dividend yield of 4.03%. The current market earnings yield of 6.75% is set against the average earnings yield of 5.34%.

All of this is consistent with Alan Kohler's commentary of January 22, Dispelling market bull, where his analysis of markets is consistent with Siegel's view: that on a current P/E of 14-15, market valuations are reasonable.

That article warns that there is an air of speculation, fuelled by private equity, that has the potential to move markets to unrealistic levels. I want to suggest some strategic responses to help cope with such a situation arising, but before looking at that it is worth quickly commenting on what realistic expectations should be for future investment returns.

Realistic expectations

With a price/earnings multiple of 14-15, indicating an annual expected return of 7% after inflation, what other results can we expect?

Let us assume the Reserve Bank succeeds in keeping inflation in the middle of its target range of 2-3% a year ? 2.5%. A return of 7% above inflation is 9.5%, lower than the average long-run return of 13% from Australian markets, which was achieved in generally higher inflation times.

What's a realistic return for a balanced portfolio going forward? With defensive assets providing returns of about 3% above inflation, and this article suggesting a return for growth assets (Australian and international shares) of 7% above inflation, you can calculate that a 60% growth portfolio will have an after-inflation return of about 5.5% a year.

This is worth keeping in mind following three boom years; it would not be wise to rely on returns achieved in this period of about 10% a year above inflation in trying to forecast your portfolio value at retirement. It could be a case of forecasting lobster and ending up with meatloaf.

Reacting strategically

We have had three years of good times, really good times, in Australian sharemarkets. That in itself causes a problem for investors. Suddenly Australian shares are a much bigger part of their portfolio that ever before, and there seems to plenty of talk that the good times are over, that it may be time to sell up and move to cash.

The first of a number of problems with this strategy is that the transaction costs are potentially huge; not in terms of brokerage, which is cheaper than ever, but in capital gains tax. Even for investors in the tax-advantageous superannuation environment, where long-term capital gains are taxed at 10%, recent gains in Australian shares are so large that this is a significant impost.

Another problem with the "sell up" strategy is that if you are wrong with your timing ? and investors often are ? you miss out on some great returns.

The more sophisticated approach is to use portfolio income (dividends, distributions and interest) and additional contributions to reposition your asset allocation towards where you want it. Right now wary investors might consider directing cash towards defensive investments (cash and fixed interest) direct property and international investments, whose returns over the past three years, although strong, have trailed those of Australian shares and listed property.

Increasing your defensive assets to your target portfolio allocation provides two "defensive" effects. First, this portion of your portfolio will not fall in the event of a market shakeout similar to 1973-74 or 1987. Second, having defensive assets will allow you to buy more growth assets at distressed values, were the opportunity to arise.

An interesting quirk of the Australian taxation system is that most people heading for retirement would be contributing to their investment portfolios, and able to use this cash flow to rebalance their asset allocation without incurring capital gains tax. Those people in retirement and drawing an income stream from their superannuation fund face a 0% tax rate, and can be more aggressive in rebalancing asset allocation without worrying about capital gains tax.


There is no need to panic about market valuations just yet.

It is wise to be proactive and think strategically about the lowest-cost way to manage any "distortion" to your portfolio that has come from the great market returns of the past three years. Add to the mix realistic expectations of future portfolio returns of 5.5% a year above inflation (for a balanced portfolio), and you can ignore all the market noise about private equity bubbles and concern over recent above-average sharemarket returns.

You can even ignore concerns about a market correction in the first half of 2007; according to academic and statistical models, the fundamental valuation of the Australian sharemarket appears to be normal. You can relax a little.