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Identifying overvalued markets

Identifying overvalued markets

Australian investors face a question that is both urgent and perennial. The share market as a whole is near its highest point ever. The ASX 200 index has more than doubled in value since the GFC lows, and despite three corrections on the way has essentially risen for ten years. Is the market over-valued? Is a major fall on the way?

The trouble is that neither question has a straightforward answer.

There’s plenty of information on market valuation. There is little doubt that on the most common valuation measures, local and international shares are trading at historic highs. This leads many investors to leap to the conclusion that the market IS overvalued, and will fall dramatically soon. If only the investment world were so simple.

The Price to Earnings ratio (PE) is a good rough guide to a share’s value, and the market overall. Lower PEs may indicate a good time to buy, higher PEs a good time to sell. There are many caveats. As an example, resource shares often defy this generalisation as investors tend to look through the commodity cycle. Another issue is that a lower PE ratio is sometimes a sign that analysts are about to drop their estimates.

No single ratio perfectly predicts the market.  To round out a quick and dirty look at market value traders may examine the Price to Book ratio (PB) alongside the PE.

As the market approached its low in 2009 the PE of the ASX 200 stood at around 9.5, and the PB at 1.3. They now stand at 20 and 2.2 respectively. The PE ratio was higher in 2013 and 2016, touching 23. The current level of the PB is the ten-year high.

The proximity to ratio highs is not a guarantee that the share market will fall soon. There is an argument that the actions of central banks over the period justify an expansion of these market measures. In other words the lowest global interest rate environment ever, and the flooding of the monetary system with stimulus funds, lowers the hurdle for investments.

Not everyone accepts this argument, and many commentators have issued multiple warnings over the last decade of a market fall to come. Traders joke about the analysts that have successfully forecast eight of the last three market pullbacks, but at some stage those analysts will be correct, as markets are cyclical by nature.

The problem is that like good comedy, timing is everything. Legendary investor Benjamin Graham said:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

At the moment investors are voting for higher share prices, taking little notice of stretched valuation ratios. Investors will need to do more to divine the turning of the market tide.

No-one can predict the future with certainty. However there is a market factor investors could find useful. Market studies show earnings revision is the most reliable indicator of share price moves. When analysts are lifting earnings estimates, share prices tend to go up. If they’re cutting profit forecasts, stocks are more likely to fall.

This principle applies to individual stocks, and is a key reason for investors to remain alert during the company reporting season. In the intense focus on the stocks that dominate a portfolio it is easy to overlook the implications for the market as a whole.

It’s important to note that most studies also show the absolute level of earnings growth is not a factor. If expectations are based around 10% earnings growth across the top companies, and the results show 8% growth, the market is more likely to fall, especially if gloomy outlook statements accompany this earnings miss. Similarly, if consensus suggests a 5% fall in profits, and they fall by 3%, a rally can follow.

In the bad old days investors were starved for information. Technology means that today the torrent of market information is overwhelming. The challenge for investors is determining what information is useful. Focusing on earnings revision may assist investors in the crucial art of market timing.

This article first appeared in the Australian Financial Review

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