Financial data house (and also a provider of financial software), FactSet released an interesting graph this week.
It looks at the US market (S&P500 index in particular) and charts the index value of the market in aggregate along with the earnings growth of constituents of the index. Over time you would expect the growth in the index value to map to the growth in earnings – otherwise, the P/E gets over or under valued. Over or undervaluation is usual in the short term. However, over time markets tend to mean revert; head towards to their intrinsic value.
Over the last year or so, we have seen a gap open, whereby growth in the index value (blue line) has been higher than growth in earnings (black line).
Some commentators point to the growing US economy and growing earnings of US companies as the driver behind the market’s recent performance. The FactSet analysis shows that indeed earnings have been growing. But the index value has been rising even more; more than is justified by the earnings growth.
Fair value of the S&P500 index should be around 11 to 17% less than it is today (depending on the baseline assumed as fair value, 5-year average P/E 15.5 or 10 average year P/E 14.1).
What about Australia?
We are seeing a similar, but not as pronounced, situation in Australia. As discussed in IM last week, the recent earnings season was quite tepid in relation to profit growth. Most sectors (with Telco, Ag, Food and Beverage the exceptions) are now trading above, and some sectors well above, their long term valuations.
Currently, the Australian market (All Ordinaries) has a forward P/E of 16.1x – above the long term average.
First Samuel’s positioning
We are cognisant of the risk of a market correction. No one can predict the timing of corrections (unless they are a spruiker, in which case run!). We respond to this risk in two ways:
1/ ensure individual equity investments are acquired on favourable valuations1 (which creates a lower downside in a correction situation, as lower P/E companies tend to have less significant share price falls), and
2/ ensure cash is available to purchase 'beaten up' companies in a correction (this is when there is often an opportunity to make excess future returns).
1 Client’s equity portfolios have an aggregate forward P/E around 10.1x, compared to the market at 16.1x.