Tuesday 24 February 2015 by Craig Swanger Opinion

The Australian share market beats the US for relative value

This article assesses three indicators of relative value for shares and concludes that while the Australian market is overvalued it is still better relative value than the US market.

“Favour substance over form. It doesn't matter if an investment is public or private, fractional or full ownership, or in debt, preferred shares, or common equity”, Warren Buffett.

In the 2015 Smart Income Report we wrote about the relative value of various equities, credit and government bond markets around the world. At the time we showed a chart illustrating the view that:

  1. Government bonds around the world were far above historic averages, no doubt the result of years of QE.
  2. Corporate bonds were around long-term averages, slightly better than average prices in the US and looking like poor value in Europe.
  3. Equities on the other hand were looking expensive in the US and at historic values for the EU and Australia.

Since then, there has been further rises in equity prices in Australia, the US and Europe. US equity prices have only been at these levels three previous times: 1929, 1996-99 and 2007; preceding the three largest share market corrections in history. But before these corrections, there were still plenty of opportunities to profit – the 1996-99 period saw near 50% more upside before the eventual correction for example.

And that’s the point of using historic ratios: they are only an indication of when risk of a correction is rising.

Below we outline three indicators of equity market risk and show that the US market continues to break new records, but the earnings growth simply doesn’t justify the departure from history. Australia shows some signs of overpricing, but certainly not to the extremes the US is experiencing.

Equities – three indicators of relative value

1. Long-term PE ratio (Shiller cyclically adjusted PE ratio)

This is one of the most common measures used to assess future returns, as the market has a history of repeatedly “mean reverting” (mean reverting simply means “returning to its average”, that is if the ratio has risen well above its long-term average, it has tended to fall back to the long-term average).

US equities have only been at their current PE ratio* three times in the past 100 years, as shown by the blue line in the chart below: 1929, 1996 and stayed above until 1999 and 2007. In each case, the market kept going up very strongly, but crashed suddenly shortly after.

Australian equities data doesn’t have as long a history, so this measure isn’t as robust, but at current levels the ASX200 is trading at a premium of 24% to its long-term average.

long term PE graph from Yale
Source: Yale University

Key points to note include:

1. The red vertical lines show the previous times that the S&P500 has been at these price earning (PE) ratio levels.

2. The red horizontal arrows show how long it took after the market correction before real values recovered to the peak before the correction.

3. Great Depression correction:

a. PE ratio passed 27.2x in Feb 1929
b. Prices kept rising until Sept 1929, then collapsed 33% in two months, kicking
off the Great Depression
c. It was 1955 (26yrs) before they recovered to the same real value

4. 1966 peak:

a. Wasn’t 27.2x in this case it was just 24.1x
b. Took 18 years to recover – inflation eating most of the value in this time

5. Tech Bubble peak:

a. PE passed 27.2x in Nov 1996
b. Prices rose another 33% after this, taking 3 years to hit their peak
c. But then fell sharply (Tech Wreck), and took until Nov 2014 to recover real
price levels

6. GFC peak:

a. During the period it took to recover from 1999 peak, PE ratios hit 27.2 again in
Oct 2007
b. 12 months later the market corrected violently

7. Technical points:

a. The blue line is the S&P500 PE Ratio. It uses the most widely used long-term
PE ratio, the “CAPE”. This PE ratio takes out short-term noises by using 10
years worth of earnings and adjusts for inflation. As such, it is principally
used to assess likely future returns from equities over 10 to 20 timescales.
This ratio was designed by Robert Shiller, winning him the 2013 Nobel Prize.
Shiller recently said that he was moving his personal wealth out of US
equities. More detail for those interested click here.
b. The orange line is the S&P500 Real Price Index. Where we show that it took
say 14 years to recover value, this means it took 14 years before the portfolio
of shares in the index were worth as much in terms of buying power, that is
adjusted for inflation.

*PE ratio: Price-Earnings Ratio. The higher the ratio, the more the market is willing to pay per $ of a company’s earnings, that is the more expensive it is.

2. Ratio of Market Capitalisation (total value of all equities) to GDP (output of an economy):

"It is probably the best single measure of where valuations stand at any given moment." -Warren Buffett, 2001

As shown below, the US sharemarket just hit an all-time high on this ratio, even surpassing the 2001 Tech Bubble levels.

Market Capitalisation to GDP Ratio, US, 1971-2015
market cap to GDP ration US

Source: FRED

The same ratio for Australian equities shows far better value at home, albeit now above average levels by around 14%.

Market Capitalisation to GDP Ratio, 1987-2015

Market capitalisation to GDP ratio
3. Margin Debt level on NYSE

One other ratio that gets followed closely is margin debt, that is total amount of debt owing against shares on the NYSE. This has reached an all time high, although it should be noted that this outcome is without question linked to the very low interest rates in the US right now. For investors that believe that rates will jump in the US, there is about US$200bn of excess margin debt that would likely be removed in that scenario. That represents around US$600bn in selling pressure, which even for the US market is a lot to absorb. For those with a view that US rates will be lower for longer, this ratio is only really a concern for the implied “irrational exuberance”.

NYSE margin debt

Source: NYSE

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