Australia 200 Index - How high could it go?

CMC Markets

As I write this blog on Tuesday afternoon, we are ending the sort of market day that's become common recently - a solid move higher without any specific news trigger.

The reason of course, is portfolio switching out of bonds and cash into equities as investors adjust to what looks like a lower risk environment. In recent times, solid starts to the trading day have themselves been attracting more buying in what's being described as a FOMO (fear of missing out) rally.

How far might this process take us? One tool I find useful in trying to make some broad sense of this question is a chart of price to earnings (PE) valuations.

Price Earnings Chart

The chart below shows the S&P/ASX 200 index as a multiple of current year earnings estimates by analysts.

The "E" in this formula is taken from a survey of analysts' earnings per share estimates for every company in the index. The combined market value of all the companies in the index is then divided by forecast earnings to obtain the index PE value.

PE values help compare and make sense of index values over time. It's not a perfect tool.  Things to bear in mind when using it include:

  • Analysts' earnings estimates are far from perfect. In particular, analysts tend to be fairly slow to adjust their published estimates. This means, for example, that what can look like an increase in price earnings might actually be the market adjusting valuations because they have increased private earnings forecasts based on say an improving economic outlook or changed industry conditions
  • PE values change as time progresses e.g just before the reporting season many companies will have over 6 months unpaid dividends included in their price

One way to overcome these problems (especially when looking at the whole index) is to use the PE as a tool to give you a broad idea of the lie of the land rather than as a precise tool for trade entry and exit

On the chart below, I have called index forward PE levels below about 13.5 or 13  "emergency levels". These were the 2 periods in recent years when the market set high risk premiums and sold shares down to low PE multiples. The first period followed the GFC';the 2nd was mainly associated with concerns over the potential breakup of the Eurozone from 2010 until late last year.

Current PE values. Source: Bloomberg

Current PE values in context

At 14.75, the index forward PE is now back into the range of valuations that applied in the bull market leading up to 2007.  Broadly speaking this range is between about 13.5 and 17 so we are still a bit below the middle.

Of course, interest rates are now far lower, so earnings yields on alternative investments like cash and bonds are lower. All things being equal, price earnings multiples on equities could be pushed even higher in this environment.

So if nothing comes along to scare investors back into bonds and cash, this broad brush PE analysis suggests the index could easily move quite a bit higher than it is now without being at extreme valuations.

A valuation increase of 10% from current levels would take the current forward PE from 14.75 to around 16.25

Monthly Price Chart

It remains to be seen whether the current rally is just a retracement of the GFC decline or part of move to all time new highs.

At this stage though, the 61.8% retracement level of 5426 is about 11% above current levels and does not seem out of the question over coming months in light of the PE analysis above.

Australia 200 CFD - Monthly. Source: CMC Tracker

Weekly Chart

On the weekly chart, there has been no correction in the latest rally which began on 2nd November last year. When the next move down does come, provided we don't overlap below the peak at "1" (4584), it is likely to be a correction against the impulsive uptrend and so a potential buying opportunity.

The next significant resistance levels are the peaks of April 2010 and 2011.

Australia 200 CFD Weekly

Daily Chart

The rally since November has formed a pretty neat trend channel on the daily chart.

The top of this channel could provide near term resistance while a break below the trend line support would be a sign of short term weakness.  A break below the early January peak at 4754 could be a typical indicator that a more significant correction is underway.

Australia 200 CFD - Daily

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