Tuesday 31 March 2015 by Craig Swanger Opinion

Are equities and bonds in a ‘bubble’?

There’s been a lot of talk in the press lately about equity markets being overvalued and in a bubble. Brokers will say one thing, equity fund managers another and the media will typically find the most sensational angle for a headline.

With Australians so heavily invested in equities, it is important to have a more considered look at the fundamentals:

1. Australian equities, overall, are NOT above long term average prices.

2. The average however covers up some issues:

a) Banks are trading at unprecedented prices (Price/ Earnings levels)
b) Other high dividend yield stocks are above long term averages, but not as much
as the banks
c) Resource stocks are making the average look more reasonable

3. US equities on the other hand are at levels only seen three times before:

a) 1929 (before the Great Depression)
b) 1999 (before the tech wreck)
c) 2007 (before GFC)

4. The concern for Australian equities therefore is that when the US market does eventually correct, there is the inevitable flow on effect for the ASX, and it will be the high P/E stocks that will wear the brunt of that, that is the bank stocks.

The charts below compare the relative value of equities and high yield corporate bonds in Australia and the US. The blue lines are equity market valuation levels, using PE ratios to measure how cheap or expensive the market is. The orange lines show the bond spreads and how much above the risk free rate that bonds are paying in interest. In both cases, the higher the lines go, the more “expensive” they are compared to the last 10 years, and the lower they go, the “cheaper” they are.

Are equity and corporate bond values outside of their normal valuation ranges?US equities are, but other markets are very close to long term averages

AUS relative value chart

US relative value chart
Five investment strategy points to make from these charts:

  1. Equity values and corporate bond spreads are normally very closely related, but the US equities market has broken away from that pattern.
  2. Equity values in Australia were last in the expensive (above 80% on the chart) territory in 2013, but now on average back around long-term average levels, ie reasonable value.
  3. Corporate bond spreads in both the US and Australia are around long-term average levels, ie reasonable value.
  4. US corporate bond spreads have corrected in the past few months, albeit gently, and therefore represent strong buying opportunities where the market has overshot.
  5. US equities have broken away from US corporate bond spreads. This means either corporate bonds need to move up in value or equities are overpriced in the US.

At FIIG we don’t offer equities or other asset classes. We are fixed interest experts. This means that every one of our clients has an interest in earning investment income. And as such, our clients are interested in where they can earn investment interest, regardless of the asset class. That is why we started the Smart Income series of thought leadership – to provide investors with a view on the relative opportunities and risks across all income producing asset classes. Naturally we spend more time talking about corporate bonds than other assets, but hopefully our economic research and unique insights can provide you with some views on other investments that help you build you income portfolio.

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