Wealth Intelligence

The market is rarely so optimistic

I have recently found myself being cautiously approached by people who want to commiserate with me about the share market and its poor outlook, in light of the “dismal equity climate”.

Notwithstanding the strong relative performance we have enjoyed (i.e. First Samuel shares v ASX), the enthusiasm I express for shares in response to these comments continues to surprise my well-meaning condolers.

However, I do appreciate that without the benefit of historical context, this must seem an almost euphoric-denial response to most.

So, with this in mind, I felt it was important to provide some more information to better explain my enthusiasm.

The technical analysis – PE ratios and stock market performance

In 2000, Pu Shen published an article in the Federal Reserve of Kansas City Economic Report with the rather stultifying title “The P/E Ratio and Stock Market Performance”.

Despite the title, the analysis was fascinating. It looked at the historic relationship between the value of the US share market (as represented by the price of a share compared to the earnings that share generates in that company’s profits – the P/E ratio) and the subsequent share market performance (from 1872 to 2000).

Now, in those days, the US market was expensive, trading on a price of 30 times the earnings of its companies (versus a 14.5 long term average). So the outcome of the study was that it predicted “substantial declines in real stock prices and real stock returns close to zero, over the next ten years”.

Of course, looking back from today, one tingles at just how accurate that statement turned out to be (the SP500 returned +6.7% over the next 10 years, which was under the inflation rate).

More recent experience

The study cited the earlier work of Campbell- Shiller that clearly showed P/E ratios are reliable at predicting future real (i.e. after inflation) returns over the following 10 years.

This study was updated in 2009, and the findings are shown in the chart on the right.

It may be difficult to see, but the P/E ratio is on the horizontal axis and the subsequent 10 year market return (after inflation) is on the vertical axis.

So, what does this mean for you?

First Hand Spring11 graph 3 1280pxW

The analysis (and chart) is complex. But what you can clearly see is the inverse relationship between the market’s P/E ratio and the subsequent 10 year performance history. In other words, there is a trend line that broadly slopes from the top left to the bottom right.

Whilst academic articles such as this are only of interest to a few of us, in practical terms all it (and many other similar studies) shows is what most “normal” people already implicitly understand.

That is, when you buy a good asset cheaply (at a low P/E) it will tend to do very well over time.

Conversely, when you pay too much (i.e. a P/E well above the 14.5 average), it will not perform that well (albeit you may feel good about it at the time).

So, in September 2011, when First Samuel shares (in aggregate) traded (at their lowest point) on a P/E ratio of 7.7, (almost half of the Australian long term average P/E of 14.6), it should not be a surprise to you that my thoughts about future client returns were the strongest they have ever been.

Where to from here?

In simple terms, the way the maths works means that to return to the long term average P/E of 14.5, the portfolio needs to provide a return of nearly 100%.

Now, this is unlikely to happen in one year, and we may see lower share prices yet.

But to someone who is investing for the long-term, and prepared to look out past the current second-by-second news flow world we live in, it is easy to be incredibly optimistic about the outlook for shares today.

IMPORTANT NOTICE:  Any advice contained in this document is of a general nature only and has been prepared without taking into account your personal objectives, financial situation or needs.
Because of that, before acting on any advice in this document, you should consider whether the advice is appropriate for you having regard to your personal objectives, financial situation and needs.