It is late April and the Australian stock market is trading at around 5300 points or around 19% higher than recent lows, and around 22% below the market top in February. Volatility has reduced somewhat from record levels. stock market

Previously, we discussed the importance of holding cash, maintaining your investment time horizon and investing for a range of outcomes. Now, we explore what the Australian stock market is telling us about the future, whilst trading at around 5300 points. 

A classic valuation tool can be useful. The ‘PE ratio’ or Price to Earnings (Profits) ratio is the price you pay for $1 of the stock market’s (previous year’s) earnings.

A PE ratio of 20, means it costs Australian investors $20 to access $1 of earnings from the stock market. PE of 20, therefore, equals a 5% earnings yield ($1 of earnings divided by $20 price paid).

When interest rates are low, the PE ratio tends to be higher, all else held equal. E.g. A 5% earnings yield (PE ratio of 20) may be reasonable when interest rates are 1%, but not when interest rates are 10%.

Growth expectations also matter.  If earnings are growing strongly, markets can trade at high PE ratios. As the ‘E’ or earnings grow, markets that appear expensive can become cheap in time. E.g. If 10% earnings growth, a PE of 20 can quickly become, 18, and then a year later 16.2.

So, what is the market telling us in late April 2020? The current PE ratio based on 2019 earnings is roughly 18.5 times, offering an earnings yield of 5.4%.

Is this cheap or expensive? The 10-year Australian government bond yield is currently just under 1%, given it is typically used to value investments such as shares, at first glance you may say the market is cheap.  

I wish it were that simple! Last year’s earnings were delivered in an environment prior to shutdowns and social distancing.  To assess the value of the market, let’s look past the depressed earnings during the shutdown phase (2020/21) as we all know it will likely be a horror or abnormal year.

What are we willing to pay for $1 in earnings in 2022? stock market

‘Bad’ scenario (medium-term earnings are impaired by 20%)

The PE ratio is 18.5 at present (market at 5300 points). If earnings are impaired by 20% from 2022 onwards, the 2022 PE ratio may be 23 (if the market trades at 5300). This gives an earnings yield of 4.3%. Compared to 1%, perhaps an acceptable return. The market is pricing in this ‘Bad’ scenario if you accept a 4.3% earnings yield. Note, this earnings yield may grow from 2022 onwards if by 5% pa, 4.3% becomes 4.5% in 2023, 4.74% in 2024 and so forth.

‘Very Bad’ Scenario (medium-term earnings are impaired by 30%)

If corporate profitability only recovers 70% in 2022 and beyond, 70% of today’s 5.4% earnings yield gives 3.8% (PE of about 26 with a 5300 market). I’d prefer a higher earnings yield (lower PE ratio) to justify the risk of owning shares here. Shares may settle 5-15% lower than where they are at present, say around 4700-5100 points versus 5300.

However, what if interest rates in this disaster scenario fall to zero? It has happened in the US, Europe and Japan. In that case, I might just put up with a 3.8% earnings yield! Even in the ‘Very Bad’ scenario, the stock market could still be hovering around present levels (5300) after a period of panic in the interim no doubt. Sure, long-term returns of 3.5-4.0% in this very bad scenario are low, but still potentially better than 0%.

‘Return to normal by 2022’ scenario (earnings fully recover in 3-4 years)

If you believe that in 2-4 years earnings will largely recover, you can make a case, compared to safe assets that shares offer good value. In this scenario, the market could rise to 5600, or even toward 6000 if either interest rates trend a little lower (thanks to the RBA intervention) and/or earnings grow. This scenario could yield returns closer to 8-10% per annum over a 3-4 year time horizon.

Summary 

Looking past the shutdown period is the way to approach this market, as earnings this year, or next, are not a reliable measure of the long-term earnings power of the Australian stock market. It appears at 5300, with low interest rates, using a ‘back of the envelope’ calculation, the market is telling us to expect, roughly, a 20% impairment of medium-term earnings whilst it is trading at 5300. Whilst we can overlook the next year or two, you should hold a view about earnings over the medium term.stocks

If you think earnings in 2022 will be less than 20% impaired compared to 2019, this may inform you of the appropriate allocation to Australian shares in your portfolio, perhaps an overweight position is warranted. If you think earnings will be impaired by a lot more than 20% in 2022, then less exposure to shares may be warranted. Just remember that interest rates and future growth in 2023 onwards matter also.  

One thing is clear, when the market touched 4500 points, it was certainly pointing to a 35%-40% impairment of medium-term earnings, that is surely a lot of bad news priced in.

As always, this exercise (forming an estimate of fair value) should be conducted with a trusted financial adviser unless you are a very experienced investor. An adviser can objectively assist you to determine both your willingness and your ability to invest in risk assets, and ultimately your personal required return (compensation) from risk assets such as shares. That is why to some, the market is cheap at 5300 and is deemed expensive by others, and both views are perfectly valid at the same time.

For more information

If you have any questions or require further information, please contact your nearest RSM Financial Adviser today.

This page has been prepared by RSM Financial Services Australia Pty Ltd ABN 22 009 176 354, AFS Licence No. 238282.

As everyone's circumstances are different and this article doesn't take into account your personal situation, it is important that you consider the above in light of your financial situation, needs and objectives, and seek financial advice before implementing a strategy.    
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