This article is from the Australian Property Journal archive
With the Australian share market pushing to near the 5000 level a month ago before undergoing a modest correction, it is reasonable to ask questions about its sustainability. After all it was only just over a year ago that we first went through the 4000 level. Are shares overvalued? Is there a bubble? How far could it go?
Key points
· Despite rising to near the 5000 level, Australian shares are not in a bubble. The market is not overvalued and investors are not yet euphoric.
· However, there is a risk a bubble may develop.
· We see more upside for local shares.
Australian shares pushing 5000
With the Australian share market pushing to near the 5000 level a month ago before undergoing a modest correction, it is reasonable to ask questions about its sustainability. After all it was only just over a year ago that we first went through the 4000 level. Are shares overvalued? Is there a bubble? How far could it go? The last time we looked at these issues in detail was in September 2005 and our conclusion was that the Australian share market was not then in a bubble, but that there was certainly a risk that a bubble may form. Now with the share market even higher, it is reasonable to review the issue again. Our assessment is little changed.
Are Australian shares in a bubble?
Share market bubbles are marked by overvaluation, extremely positive investor interest, a high level of capital raising and a narrowing in share market strength. While there has been some deterioration in terms of the latter, there is no sign of a bubble in terms of the first three, so our overall assessment remains that Australian shares are not in a bubble.
First, local shares are still cheap. Our analysis shows shares remain at the low end of their fair value range, with fair value being around 5500.
Source: Datastream, AMP Capital Investors
The main reason for this is that since 2001 share prices have lagged behind profits. For example, over the last two years the share market is up 45% but earnings per share rose 47%. Through 2005 the share market rose 17.6% but earnings per share rose by around 22% based on results for the December half reporting season. This contrasts with what happened in 1987 when shares jumped 90% in the 12 months to their peak, but earnings growth was 25%.
Source: Datastream, AMP Capital Investors
The Australian share market’s high dividend yield also underpins the market’s attractive valuation. The dividend yield grossed up for franking credits is only just below the 10-year bond yield and is well above the yield on rental housing. Stronger than expected dividend growth was a key feature of the December half reporting season.
Source: Datastream, AMP Capital Investors
At 14.5 times the price earnings multiple (calculated using 12 month ahead forward earnings) is still just below its ten year average of 15.1 times. It is also well below its late 1990s high of 18.3 times.
Some have argued that Australian shares are now expensive versus global shares because they are trading at a similar forward PE to global shares compared to a discount in the 1990s. It should be noted though, that the 1990s is not a great point of comparison as Australian shares were priced at a discount reflecting the aftermath of the corporate scandals of the late 1980s, Australia’s high inflation track record and because they missed out on the IT bubble. With Australian shares over the last decade generating better earnings growth than global shares – despite paying out a higher proportion of earnings as dividends and with lower risk – there is no reason why Australian shares should be trading at a discount.
Secondly, while investor confidence in Australian shares is up, we haven’t seen the euphoria which normally accompanies bubbles. The proportion of consumers nominating shares as the wisest place for savings is well below peak 2000 levels. Inflows to equity funds are running at solid but not boom time levels. Foreign investors appear to remain underweight Australian shares.
Source: Melb Institute/Westpac Consumer Survey, AMP Capital Investors
Thirdly, while net equity raisings have picked up, relative to market capitalisation capital raising is not excessive as is usually the case in share market bubbles.
Finally, while signs of a narrowing in share market strength suggest we may be entering a bubble phase, this conclusion is ambiguous. The final stages of share bubbles are often characterised by a narrowing in investor interest to a few sectors/stocks. Over the last year we have certainly seen this with resources shares. But the normal outworking of this during a bubble, i.e., a big widening in valuations, is still not yet evident. The chart below shows the spread between the top 25% of shares, less the bottom 25% of shares in terms of PEs. Market bubbles see a widening in PE dispersion with some shares trading on exorbitant PEs (eg, technology shares in the 1990s) and others on very low PEs. So far this is not the case.
Source: Citigroup, AMP Capital Investors
Low PE dispersion means that it is hard to find stocks that have been overlooked in favour of others, which partly explains the refrain of value managers over the last few years that it is “hard to find value in the market”.
Australian versus global shares
Over the last six years, Australian shares have outperformed global shares and made record highs, whereas global shares are still below their previous year 2000 highs. This has led some to claim the Australian market is ahead of itself and due for a reversal. But it isn’t that simple. Over the last 25 years, Australian and global shares have had similar capital gains. As indicated below, the out performance by Australian shares (in local currency terms) over the last six years is really just a catch up to their under performance in the 1990s when global shares experienced the IT bubble. This is far from suggesting they are about to under perform. The problem has been with global shares and the IT bubble which engulfed them in the late 1990s, not Australian shares.
Source: Datastream, AMP Capital Investors
But could a bubble be developing?
While the Australian share market is not in a bubble, we continue to see the “risk” of one developing as being high.
· The swing from IT stocks (i.e. the centre of the last bubble) to “old economy” shares such as resources and higher yielding shares that have a high weighting in the Australian market may have further to run.
· The rise of China is adding to this by providing a positive displacement, which is clearly supportive for Australian resource stocks.
· Low yields on alternative assets are attracting investors into shares.
These considerations could easily see local shares pushed much higher. Obviously there is no clear answer as to how high it could go. But if the market were to rise to the past peak in the forward PE in 1999 (i.e. 18.3 times) this would imply a rise to around 6100 for the ASX 200 (without assuming any change in forward earnings). (Note that this estimate will move up as earnings rise.)
Conclusion
Our assessment remains that Australian shares are not in a bubble. Valuations remain reasonable, investors are not euphoric and while there has been some deterioration in the breadth of share market participation this is not evident in relative valuations between sectors. However, there is a “risk” that a bubble may develop and it is likely to become an increasingly volatile ride for investors. Either way we see further gains in Australian shares this year.
Dr Shane Oliver, chief economist and head of investment strategy at AMP Capital Investors.*
