The Price:Earnings (PE) ratio is a popular tool for assessing whether a share, or equity market, looks cheap or expensive. Mike Browne of Seed Investments has undertaken some detailed research on the ALSI’s PE ratio and cautions it is likely that returns from Johannesburg-listed stocks will disappoint over the next year.
The good news is that Mike doesn’t think there’s a bigger chance than usual of a market crash. Nevertheless, you might want to think about taking some profit and sitting tight, is his message. He explains his thinking in his latest blog, published here on Biznews.com. – JC
By Mike Browne
One of the main tools we use at Seed to determine whether the local equity market is expensive or not is the ALSI’s historical PE ratio. We have seen that, over time, a low starting PE ratio has typically resulted in excellent returns to investors over a 5 year period, while a high starting PE has typically resulted in relatively
poor 5 year returns.
Chart 1 ( Starting ALSI PE v Subsequent 5 Year Return) demonstrates this relationship, with each blue dot indicating a starting PE level and subsequent 5 year return (annualised). From this chart one can see the relationship between starting PE and subsequent return and that the market is currently extremely expensive.
The logical (often rhetorical) question that we get asked after showing this information to clients or other investment professionals is, “I guess that means that you expect a significant market correction sooner rather than later?”
Intuitively we’d typically agree with this statement, but we delved a little deeper into what’s happened in the past in expensive markets (i.e. when the starting PE of the ALSI was above 17). It was interesting to note that on a 12 month horizon, investors had a similar chance of losing capital when the market was expensive (i.e. PE above 17) as across all market conditions (all observations). Chart 2 (12 Month ALSI Returns – Various Criteria) indicates this phenomenon.
This analysis indicates that investors into local equity should expect negative 12 month returns approximately 1 in every 5 years if they don’t take heed of starting valuations. When the market is expensive (PE above 17), this ratio is similar. What is interesting is that when markets are expensive, the probability of good returns (i.e. in excess of 20% pa) falls right down to approximately 10%, compared to a 50% probability over all periods in the analysis (322 observations).
Chart 2 also indicates the power of investing when the market is cheap (i.e. PE below 10). In these periods investors have received a 12 month return below 10% less than 10% of the time compared to returns in excess of 20% (over 12 months) in 80% of the observed periods.
From this (admittedly simple) analysis we can conclude that while we don’t think there’s a heightened chance of a market crash when compared to history, investors should brace themselves for the high probability of sub optimal returns over the next 12 months. Investors should also be aware that should there be a fall in markets, it is highly likely that it will be larger than a typical correction.
As a result of this, and other, analysis the asset allocation Funds that Seed manages (namely Seed Flexible Fund and Seed Absolute Return Fund) are currently conservatively positioned, using local equity as a measure, compared to historical and strategic weightings.
Mike Browne started his investment career with Exsequor Investments (Seed’s forerunner) in 2005 after graduating from the University of Cape Town with a BBusSc (Finance) degree. While working at Seed, Mike successfully passed all three CFA exams, and was awarded his CFA Charter in 2009. Mike currently manages Seed’s unit trusts and spends a large portion of his time conducting investment research and meeting fund managers. Mike is on the Investment Committee and is a Portfolio Manager at Seed Investments.