January 20, 2010
PORTFOLIO POINT: As the ASX 200 closes in on 5000 points, historical averages point to where it might go in 2010, and when it will reach new milestones.
Remember that when the ASX 200 or the All Ordinaries index are discussed, it is generally the "price index" that is quoted. The price index measures the price movement of shares over time, weighting shares in the index based on the company size. The other key index is the "accumulation" or "total returns" index. This is calculated to include the value of dividends and the change in price of the listed shares. The Accumulation index is, in a lot of ways, more appropriate for investors to be aware of, as investors who own shares receive the benefit of both price movements and dividends.
For the record, the ASX 200 accumulation figures closely mirror the better known ASX 200 price index. The ASX 200 accumulation index is currently at 33,921 points. At the top of the market in November 2007, it peaked at just over 42,500 points. At its low point the index fell below 22,000 points in March 2009.
The table (above) shows the cumulative returns of the ASX 200 index, and the ASX 200 Accumulation index (the index including dividends). Over five years the rise in share prices has been 20%; less than half the accumulated total returns from owning shares of 49%. In other words, dividends have provided more than half of the returns from owning shares over the past five years.
It is worth keeping in mind that the Accumulation index does not include the value of franking credits - which would provide a further return of around 1.5% a year - or, with compounding - just over another 7.5% cumulative return.
So, comfortable with this suite of figures and market information, can we look ahead? We can try. Let's use those historic returns to extrapolate when the ASX 200 will hit 5000, 6000 and a new high of 6900 points?
Early last year the French-based global investment bank Credit Suisse published a report entitled Global Investment Returns Yearbook, authored by academics from the London Business School.
The report focuses on the long-run return experiences of investors in markets around the world, and can be downloaded here.
It found that the real (after inflation) return from Australian shares between 1900 and 2008 (to the end of 2008; that is, including the majority of this current downturn) was 7.3% a year.
This is a very welcome approach. It is important to look at after-inflation returns, which indicates the change in the purchasing power of an investment in shares over time. We can use this, along with an estimate of inflation and dividend yield, to make some observations about where markets might be in time if the provided performance stays in line with averages - an approach which is, of course, entirely theoretical.
That's because markets tend not to provide performance in line with the average, tending to be well above or below over shorter periods, so this analysis is more for interest, rather than something that should be relied upon in any way.
So, if we assume that inflation stays at the top end of the Reserve Bank's 2-3% target band, then it will be 3% a year. (This is a significant assumption.)
The current market yield is 3.9%. (Estimates of yield vary, however 3.9% seems to be about the average).
The total expected return for the market is the real return (7.3%) plus inflation (3%), giving a total return of 10.3%. Of this, 3.9% is dividends, leaving 6.4% of the return coming from growth in share prices each year. That allows us to calculate where, given long-run average returns, the index may be in the future.
This would see the Australian sharemarket, measured by the ASX200 index, pass through the 5000 point mark in the first half of this year (at the moment it is only two or three good days away). It should go through 6000 points in early 2013 and reach new highs about the middle of 2016. Keep in mind that this simple analysis ignores market volatility completely: it is just looking at average returns.
Taken at face value this would mean that markets have taken almost nine years to reach the highs of 2007. This might not compare very well with those 20% returns forecast by leading players in the market, which would see the markets at about 5500 by the end of this year.
Why the gap? Well, there are two key reasons that markets may reach new highs prior to 2016. The first relates to earnings growth; the long-run real (after inflation) growth in earnings of shares (according to the Credit Suisse report) is 2% a year. This is a key statistic for investors: they own an investment that increases earnings (and therefore dividends) at a rate of 2% more than inflation annually.
In the recent downturn, company earnings have decreased. Forecasts are for company earnings to increase over the next 12 months with everyone looking to the February reporting season for evidence of this.
The forecast earnings rebound is strong, and if this eventuates and earnings continue to grow over the next five years then this may push markets higher by 2016. We saw a number of companies upgrade their earnings yesterday; Flight Centre flagging a 60-80% increase in profits, Collection House a 30% increase in underlying profit, and Computershare a 20% increase. Harvey Norman reiterated expectations of a 40% rise in first-half profits, with Commonwealth Bank also flagging a 44% increase in cash profits late last week.
The second reason markets may reach new highs is their tendency to overreact. The authors of the Credit Suisse report note that markets have a tendency to overshoot, and the "scale of overshooting either side" is "very large". If markets have overreacted to the current downturn, they may recover more quickly.
One more thing: It is interesting to look at the past five years in the context of some of the doom and gloom commentary about what a "difficult period" it has been for investors. An investor who captured the average market return over the past five years (to the end of December, 2009), and invested $100,000 at the start of 2005, would now have a portfolio valued at $149,000 - even after all the trials and tribulations of the second biggest market downturn in Australian history (behind the market downturn in the early 1970s).