The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Wednesday, April 7, 2010

Are Australian shares overvalued?

Uh, oh! Is the RBA telling us that the Australian sharemarket is overvalued? Quite possibly. Based on the RBA’s latest macroeconomy chart-pack, it has found that the Australian sharemarket's price-earnings (P/E) multiple is currently at its highest level since records began prior to the 1980s (refer to the chart below).

Now you don’t often hear a sharemarket obsessed media talk about that. No, it is much more interesting to fan the housing hysteria. Why does it matter? Because around 70% of all Australian superannuation savings are invested in Australian and international equities. In the pre-super days this money used to be stashed away with banks and re-allocated throughout the economy in the form of much lower risk credit. But not any more.

According to the RBA, the Aussie sharemarket's current P/E ratio is substantially higher than it was immediately before the 1987 crash, the 1991 recession, the 1997-98 Asian crisis, and the great credit crunch of 2007-08. This should be disturbing news for mums and dads.

Equities spruikers will doubtless argue that the RBA’s P/E ratio compares current prices, which reflect expectations of future earnings, with current cash-flows, which are definitionally historical in nature.

But in order for this ratio to right itself and converge back to a level that is more reflective of long-term trends one would need to see either a significant stagnation or fall in share prices, or a very strong rise in corporate cash-flow.

Investors are clearly punting on the latter. But it is certainly a punt given the very modest nature of Australia's economic correction during the GFC. Indeed, since the ASX All Ordinaries Index, which currently stands at 4,983pts, is still nearly 30% off its November 2007 peak of over 6,800 pts, it is hard to fathom how there is much upside in the market.

Now your typical super fund advisor will have a rather random 50:50 split between Australian and global equities in their “model portfolio”. But as the next RBA chart below shows, there is virtually no diversification benefit from taking this approach (notice how the US equities (red), Australian equities (black), and global equities (blue) lines all move in near unison).

In fact, global equities have underperformed Australian government bonds in raw terms, and dramatically more so in risk-adjusted terms (ie, accounting for the much higher volatility of shares), over the last three decades.

There are two key take-aways here. First, before you dive into shares think about the current valuation metrics while bearing in mind the Australian equities market's extraordinary 20% per annum historical volatility (ie, probability of loss). Second, super fund trustees need to start interrogating their advisors' model portfolios more carefully.