Are Australian Equities Good Value?
Whenever we review equity market valuations, it is necessary to do so in 2 contexts:
- Absolute terms – i.e. versus itself over time and
- Comparative terms - i.e. versus bond yields and where applicable international peers.
Source: MarketIndex 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.
Firstly, in broad brush terms, there has been a gradual PER expansion over the past 4 decades from around 10x earnings to around 15x times. We see this as well founded and structural as opposed to transient or temporary.
Secondly, the June market valuation at 16.5x earnings is above both the long term average of 15x and the more recent 10 year average of 14.3x earnings. However it is not excessive and is well positioned in the broader trading range that has dictated terms since the mid 1980’s between 15x and 20x earnings.
Thirdly, the dividend yield at 4.5% is actually above both the 10 year average (4.4%) and the long term average (4.1%). This is baffling, given that the official cash rate and Commonwealth Government Bond (CGB) Yields are the lowest in recorded history.
Figures 2 and 3 (in particular) provide some clear insights on a comparative basis.
Source: Katana Asset Management & Bloomberg
In Figure 2 we can see that the Australian equity market has kept in sync with global stock markets as measured collectively by the MSCI World Index. This is consistent with the experience of the past decade.
Source: Katana Asset Management & Bloomberg
In Figure 3 however, we note that any connection between bond yields and dividend yields has completely broken down. Whilst the market dividend yield remains a healthy 4.5%, the 5 year CGB rate has dived to 1.6% - the lowest on record. This has further increased the differential between bond yields and dividend yields to almost 3% - the 2nd highest gap on record. Only the panic that emerged during the GFC created a brief gap of 4% 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; whilst dividend yields are downright attractive. Net for net this would equate to a positive stance on equities.
And 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 interest rates.
Swiss Government Bond Yields are now negative out to 30 years. That means, that if you lend the Swiss Government money for anywhere up to 30 years, you actually pay them!
The Dutch 10 Year Government Bonds are also paying a negative rate….for the first time in their 500 year history. No, these are not ordinary times.
Source: 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 bath water during periods of heightened risk and fear.
We believe that a more appropriate question to ask 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 presented for nearly 2 hours on the heightened risks that confront our global economy.
But at the highest level, we see four (4) key macro risks that investors should be cognisant of.
Four (4) Key Macro Risks
The first key risk is that the US bull market is growing long in the tooth. The average US bull market extends for 7 years and we are now in the 8th year - the second longest since WW II. Whilst 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 index has rallied from a low around 6,500 to a recent record high of 18,600 – a move approaching 190%. Recently the up-trend broke, and we are now awaiting to see if this market can regain its momentum (refer below).
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 (BOJ), US Federal Reserve or European Central Bank ECB or non-government institutions ranging from non-financial debt through to margin lending (which has just hit a new high in the US, 50% above the pre-GFC level).
Thirdly, 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 has exploded from 121% of GDP ($US2.1tr) in 2000 to 290% ($US30.0tr) by 2015. Even more alarming is the rate at which this increase is increasing. A decade ago, the Chinese Central Government was spending 15% of GDP. 3 years ago that increased to more than 20%. For 2016, Chinese Government spending is forecast to be >27% of GDP.
Finally – and most critically – confidence in the central banks is beginning to wane. The 3 issues outlined above are ‘known knowns’. And 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 the Central Banks can navigate a way out of this crisis. If investors en masse lose confidence in the capacity of the Central Banks, then this becomes self-fulfilling and self-perpetuating.
Short Term Outlook
In the short term, the 2 major US Indices are demonstrating characteristics of a ‘break-out’. 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, that you realise it.
So in summary:
- Australian Equities are trading in line with historical valuations in ‘absolute’ terms
- On a comparative basis, the ASX is fairly priced but with an above average yield
- These are not normal times; there are a number of significant macro headwinds that investors need to monitor
- 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.
Romano Sala Tenna is a Portfolio Manager at Katana Asset Management. The Katana Australian Equity Fund is a long-only, broad-cap Australian Equity fund focused on maximizing risk adjusted returns for clients. This article is general information and does not consider the circumstances of any individual. To learn more about the Katana Funds, please click here.