Are shares too expensive now to buy?
Key points
Principle valuations for equities are of great importance in terms of return potential in the medium term and vulnerability to falls in equity markets. In short, the cheaper the better.
Developed market shares are not cheap (and not for some years), but with most measures they are not in overvalued extremes. US stocks run the greatest risk, but other markets are reasonable.
Introduction
Some commentators claim that stocks are overvalued and so a crash is inevitable. As always, it is a lot more complicated, but given the current turbulence on equity markets, it is worth checking whether stock markets are expensive or not as a guide to how vulnerable we are to continue. More in general, valuation measures provide guidance for future return potential.
Why appreciation is important – the cheaper the better
First a little background information about appreciation. A valuation measure for an asset is in fact a guide to whether it is expensive or cheap compared to the income that it generates. Simple valuation measures are price / earnings ratios (R & D) for equities (the lower the better) and yields, ie the ratio between dividends, rents or interest payments in relation to the value of the asset (the higher the better). A clear example of where the basic valuation is of critical importance is money. For some years now, deposit rates on bank accounts have been historically low, which means that the return is low and the value is poor.
For government bonds, the yield is also a good guideline for value. In the medium term, the main reason for the return that a bond investor will achieve is what the bond yields were when they invested. Although the relationship is not perfect, it can be seen in the following chart – which shows a scatterplot of Australian bonds with a maturity of 10 years (horizontal axis) against subsequent 10-year yields from Australian bonds based on the Composite All Maturities Bond index (vertical axis) – that the higher the bond yield, the higher the subsequent 10-year yield of bonds.
Australian bonds
Source: Global Financial Data, Bloomberg, AMP Capital
Again, despite a slight increase over the past two years, bond yields remain low, so low yields may be expected from bonds.
A similar relationship applies to shares. The following chart shows a scatter plot of the PE ratio for US stocks since 1900 (horizontal axis) against subsequent 10-year total returns (ie dividends and capital appreciation) from shares. Although it is not as flexible as with bonds, because there are more shares involved, this indicates a negative relationship, ie when the share prices are relatively high compared to the profit that follows, the returns are relatively low.
US stocks
Source: Global Financial Data, Bloomberg, AMP Capital
The following chart shows the same for Australian stocks. Again, there is the expected negative relationship between the level of the PE and the subsequent total revenue (based on the All Ords Accumulation Index).
Australian shares
Source: RBA, Global Financial Data, AMP Capital
The key is that the starting point valuation is important. The higher the yield (or the lower the PE), the better.
Complications to be aware of
Of course there are several pitfalls with valuation measures that investors should be aware of:
Sometimes assets are cheap for a reason (value traps). This is more often associated with individual stocks, for example a tobacco company that is subject to an impending lawsuit. These traps can only be picked up through thorough research.
Valuation measures are a poor guideline for timing. For example, if an investor sold shares in 1996, when Fed chairman warned Greenspan of “irrational exuberance”, they would not have done so because the shares increased for another four years. Australian homes have been overvalued for almost 15 years, but that has not been a guide to predicting a fall in house prices. The key is to have a thorough investment process that depends on more than just valuations.
There is a huge range of stock market valuation measures. For example, the “revenues” in the PE calculation can be the profit reported in the last twelve months, consensus expectations for the coming year, or gains smoothed to remove cyclical distortions. All have their pros and cons. For example, the historical PE is based on factual data without forecasts, but can give the wrong signal during a recession, because the income may collapse more than the share prices and the PE may therefore not issue a buy signal.
Finally, the correct valuation level may vary, depending on the environment. For example, in a period of low inflation and low interest rates, it is known that assets can be traded on lower returns when the yield / interest rate structure in the economy falls. This in turn means higher PE & # 39; s. So low inflation, say up to about 2%, can be good for stocks through higher PEs. But if the inflation goes from “low” to deflation, it can be bad, because it is usually accompanied by poor growth and thus shares trade on lower PEs.
The message of all this is that the valuation of stock markets is important, but you should ideally assess it together with other indicators if you try to time market movements. The key is to recognize that when a series of valuation measures are extreme, they are likely to give a signal that should not be ignored.
So what are the current valuations of the stock market valuations?
Let’s start with price-earnings ratios using historical income, that is, income that has been reported in the last 12 months. In the US, this PE is currently around 21 times, which is consistent with subdued medium-term returns based on the second scatter plot on the previous page. But in Australia at about 15.3 times it is consistent with reasonable returns over the medium term according to the third scatter plot on the previous page. Of course, current levels for historic PEs in the US and Australia are both associated with a very wide range in terms of later returns in the past. In addition, PEs are not fully reliable on the basis of historical income given the cyclical volatility of the reported revenue.
Therefore, it is probably more useful to calculate the ratio between price and profit with predicted earnings of 12 months ahead. These are shown in the following chart for global equities, the US and Australia. None is far too far from their averages since the beginning of the 1990s, but in relative terms, US shares on a forward PE of 16.1 times remain a bit expensive, albeit less than earlier this year, and global equities are a little cheap in exchange for a forward PE of 14.2 times thanks to cheap markets outside the US
Forward PEs
Source: Thomson Reuters, AMP Capital
In emerging countries, the average forward PE is fairly low around 10 times.
The following chart looks at the price / earnings ratio, calculated on the basis of a 10-year moving profit average, which is often referred to as the Shiller PE (after economist Robert Shiller) or the cyclically adjusted PE. At this size, American stocks are clearly more expensive than since the technical boom. But markets outside the US, including Europe and Australia, are not expensive at all. It should also be allowed that the ten-yearly average profit calculation is distorted by the collapse of the profit ten years ago. Because the income increase in 2008 and 2009 is going to fall outside the calculation, the American Shiller PE will start to decline. Yet there is a better value elsewhere.
Cyclically adjusted price / earnings ratio
Source: Global Financial Data, AMP Capital
Finally, it is worth looking at the stock market valuations that allow us to still be in an environment of relatively low interest rates and bond yields. In the following graph, the 10-year bond yield for the US and Australia is subtracted from their income returns (using term profits). This actually gives a kind of proxy for the risk premium on shares – the higher the better. Although this gap is clearly lower than the high GFC figures, it is still reasonable, indicating that equities are even more attractive than bonds. Of course, this will change as bond yields go up, but as we have seen in the last two years since the achievement of bond yields, this is likely to remain a relatively slow process.
Shares are still not expensive compared to bonds
Source: Thomson Reuters, AMP Capital
The general impression is that measured against their own history, the markets for developed countries are not dirt-cheap, but they have not been there for some years and they are not in overvalued extremes. The biggest risk relates to the US equity market, but the valuations of other markets are reasonable. So although the fall in stocks we’ve seen in recent weeks could go even further, such as concerns about interest rates in the US, trade between the US and China, rising oil prices, problems in the emerging world, President Trump and the US final election and the Italian budget continues to exist – at the very least, most equity markets do not oppose overvalued extremes that could underline the downside risks
