Are Australian shares good value?

Absolute valuations

Sources: Market Index and Bloomberg

Figure 1 summarises the dividend yield and trailing or historical price-earnings ratio (PER) for the All Ordinaries Index from January 1980 to the present. A number of points are worth noting.

First, in broadbrush terms, there has been a gradual PER expansion over the past four decades from around 10 times earnings to around 15 times. We see this as well founded and structural, as opposed to transient or temporary.

Second, the June market valuation at 16.5 times earnings is above both the long-term average of 15 times and the more recent 10-year average of 14.3 times earnings. However, it is not excessive and is well positioned in the broader trading range that has dictated terms since the mid-1980s, between 15 and 20 times earnings.

Third, the dividend yield at 4.5 per cent is above both the 10-year average (4.4 per cent) and the long-term average (4.1 per cent). This is baffling, given that the official cash rate and Commonwealth Government bond yields are the lowest in recorded history.

Comparative valuations
Figures 2 and 3 (in particular) provide some clear insights on a comparative basis.

Sources: Katana Asset Management and Bloomberg

In Figure 2 we can see that the Australian equity market has kept in sync with global sharemarkets as measured collectively by the MSCI World Index. This is consistent with the experience of the past decade.

Sources: Katana Asset Management and Bloomberg

In Figure 3, however, we note that any connection between bond yields and dividend yields has completely broken down.

While the market dividend yield remains a healthy 4.5 per cent, the five-year Commonwealth Government bond (CGB) rate has dived to 1.6 per cent, the lowest on record. This has further increased the differential between bond yields and dividend yields to almost 3 per cent, the second highest gap on record. The panic that emerged during the GFC created a brief gap of 4 per cent for a couple of months, before narrowing.

From an assessment of absolute and comparative data, it is clear that valuations are full but not stretched, while dividend yields are downright attractive. Net for net, this would equate to a positive stance on equities.

Ordinarily, we would predominantly be satisfied determining our macro stance based on an assessment of market valuation. But these are not ordinary times.

Are we asking the wrong question?
More than half of all bond issuances are now paying negative rates. Swiss Government bond yields are negative out to 30 years. That means if you lend the Swiss Government money for anywhere up to 30 years, you actually pay it.

The Netherlands 10-year government bonds are also paying a negative rate – for the first time in their 500-year history. No, these certainly are not ordinary times.

Sources: Deutsche Bank, Bloomberg, GFD

So the question, Are Australian equities good value?, is perhaps the wrong question to be asking at this particular juncture. Valuations are thrown out with the bathwater during periods of heightened risk and fear.

We believe a more appropriate question is, What is the state of the global landscape and what is really important at this time? Even beginning to answer that question is a task that requires considerable time and consideration. For example we recently gave a presentation for nearly two hours on the heightened risks that confront the global economy.

Four key macro risks
But at the highest level, we see four key macro risks that investors should be cognisant of.

The first key risk is that the US bull market is growing long in the tooth. The average US bull market extends for seven years and we are now in the eighth – the second longest since World War Two.

Although the experience of the Australian index is that it declined from 6,873 in November 2007 to around 5,600 today, in the US the Dow Jones has rallied from a low around 6,500 to a recent record high of 18,600 – a move approaching 190 per cent. Recently the uptrend broke and we are now waiting to see if this market can regain its momentum.

The second issue we see is the explosion of debt globally; we have solved a debt crisis with more debt. At every juncture we see debt rocketing to new levels, whether that be through central banks such as the Bank of Japan, US Federal Reserve or European Central Bank, or non-government institutions ranging from non-financial debt through to margin lending (which has just hit a new high in the US, 50 per cent above the pre-GFC level).

Third, we are concerned about the sustainability of China’s policies. China is gorging on debt at a rate that is simply unsustainable. According to McKinsey Global Institute analysis, Chinese debt exploded from 121 per cent of GDP ($US2.1 trillion) in 2000 to 290 per cent ($US30 trillion) by 2015.

Even more alarming is the rate at which this increase is increasing. A decade ago, the Chinese Central Government was spending 15 per cent of GDP. Three years ago that increased to more than 20 per cent. For 2016, Chinese Government spending is forecast to be around 27 per cent of GDP.

Finally, and most critically, confidence in the central banks is beginning to wane. The three issues outlined above are “known knowns”. Ultimately the markets can move ahead for many months or even years to come despite these issues, if – and only if – investors continue to have confidence that central banks can navigate a way out of this crisis. If investors in their masses lose confidence in the capacity of central banks, then this becomes self-fulfilling and self-perpetuating.

Short-term outlook
In the short term, the two major US sharemarket indices are demonstrating characteristics of a breakout. This would not be surprising given the high level of cash sitting on the sidelines and the inherent fear that fund managers carry of missing the next leg-up.

At the time of writing, this move is yet to consolidate. If it does, it should be clear that this is driven by sentiment and weight of money as opposed to the underlying fundamentals.

Investors need to determine if they wish to ride the short-term wave of sentiment, or focus on the longer-term fundamentals. Neither approach is right or wrong per se. But the former does carry greater risk and requires a higher level of skill and experience; and it is critically important that if you are taking this approach, you realise that.

Conclusion

1. Australian equities are trading in line with historical valuations in absolute terms.
2. On a comparative basis, the Australian sharemarket is fairly priced but with an above-average yield.
3. These are not normal times; there are a number of significant macro headwinds that investors need to monitor.
4. In the short term, we are watching for a potential index breakout; over the medium to longer term, we remain cautious given the heightened level of fundamental risk.