Data Diary

Macquarie with some science behind a 12.3x PE ratio

Posted on 27 May 2010

Sometime back we suggested that the PE ratio for the equities market was likely to fall relative to recent decades.  Based on some spurious pointing at historical 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 4250.

Macquarie in strategy piece released on 25 May 10 have come to a similar conclusion.  Their analysis is based on the premise that we have moved into a period where cycles are likely to be shorter and sharper.  This means growth on average will be lower – they assume GDP growth will be more like 2.9% than the recent 3.5% per annum:

And that this will lead to a contraction in the average 1-year forward PE to around 12.3x:

But more than that, the volatility in earnings arising from these shorter cycles also leads to wider trading around this perceived fair value PE ratio.

All makes sense to me.  Just that my chart pointing was quicker and has fewer assumptions.

Conclusion

That the market found support around 4200 is consistent with our thinking that it represents reasonable long term value.  With our risk indicators having started to calm with the consolidation in the markets, expect equities to trade higher in the short term as investors cling to recent history with respect to valuations and earnings.

On a wider angle, it’s hard to believe that we have found the bottom on this wash-out.  Until the US or Chinese governments step into the breach, I’m expecting the downtrend to prevail, and I suspect that they will keep their powder dry until the market has stretched itself to the point of exhaustion.