All Ordinaries PE ratio from 1974 to 2010
Posted on 14 April 2010
Following from the previous post (here) that suggested that ‘fair value’ for the All Ordinaries is around 4250 – just to clarify, I’m using the term ‘fair value’ as an indicator of where I’d be willing to overweight equities. Not sure how this compares to a forecast from a broker calling for 5500 for the index?
But as to why a PE of 12x looks both likely and a good entry level – consider the following chart:
Post the 1987 crash the market flirted with a PE of 12 on a number of occasions – each time bouncing from that level. Given where we are in the ‘recovery’ both domestically and internationally, and the ever stretching rubber band in risk appetite, the odds of a clean-out are pretty good. Just a question then of where your risk tolerance kicks in…
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[...] charts, we came up with an expectation that the average PE ratio might be more like 12x (see here). On our numbers that suggested ‘fair value’ was around [...]
The PE using trailing one year earnings has almost no correlation with the forward one year or ten year return. What you want is the PE that uses inflation adjusted earnings over a longer period of the past (or better the P/E ratio based on the present trend-earnings, now about 30% above the recent earnings). Since 1870, using Shiller’s US data the CAPE ratio average was about 13, presently sitting at about 20 so 50% overvalued. CAPE is not as good as looking at the trend-real-earnings but it is close enough and a convenient approximation. For the All Ordinaries the situation isn’t so bad but we’re still overvalued by about 25%. This doesn’t forecast much about the returns one year ahead from here (although better than looking at the trailing 12-month P/E) but says a *lot* about the expected 10 year returns which will be only one or two percent (real) per year on average based on the All Ordinaries sitting at 4338 and trend earnings 30% below their present value and assuming and ending value of the Price to Trend Earnings of 11 (not assuming ending at a level below this average since 1870). The average CAPE using Shiller’s US data is 13 but Australian equities tend to use P/E multiples about 15% below the US multiples (which is where I get the 11 ending value for CAPE). Of course the CAPE can undershoot 11 significantly also so returns could be much worse than this even after 10 years but they’d then be compelling value so assuming an end CAPE value of 11 is reasonable.
Real earnings have increased 1.5% per year since 1870. The total total real return has averaged about 6.5% per year (the difference being from dividends) since then. As earnings are now about 30% above the trend, assuming they will grow at the historical average rate over the next 10 years, you’ll expect the total real return to be about 6.5%. However if you chart the All Ordinaries earnings over the long-term adjusted for inflation there is almost no way to project a line through it that does not say that we are well above the trend and earnings will at some point be quite far below where they are now. So if the valuation ends at the average trend-earnings 10 years into the future then the valuation needs to be reduced by 30% which shaves off 3.5% from the total return (1 – 0.7^(1/10)) so the expected real total return will be about 3% average. With the massive debts to GDP everywhere unmatched throughout history I’m assuming another 1.5% shaved off, so say 1.5% real return.