Is the market attractive right now?
Investors endlessly follow the gyrations of the market but often ignore valuation levels which drive returns over the long-term.
It has been a strange and challenging time to be an investor. After a two-month COVID drop markets rallied as governments and central banks fell all over themselves to shovel money into the economy.
Low interest rates boosted valuation levels and left investors with little option but to plough more money into the share market. Entrepreneurs and established business found their cost of capital plummet which made any idea seem like a worthwhile investment.
As conditions started to change we all went through a collective period of denial. We proclaimed that inflation was transitory. We admonished each other to buy the dip. We postulated that interest rates cuts were just around the corner.
And as share and bond prices fell throughout 2022 and a more realistic outlook started to coalesce the world got introduced to ChatGPT. After a period when conventional intelligence let us down at every turn, we decided to give the artificial variety a shot. Afterall it could write cover letters, compose mediocre poems, and even render an image that a moderately coordinated two-year-old could draw.
Will AI change the world? I have no doubt. However, the most immediate impact was on the US share market. The magnificent seven surged in price and dragged otherwise moribund indexes upward.
It was time to celebrate. Share prices in the US surged. The bear market was over. Forget stubborn inflation and increasing interest rates. Ignore geo-political uncertainty, a pile of debt and still high valuation levels.
Things looked a little different in Australia. The market muddled on. There wasn’t a huge drop in 2022 and there wasn’t a huge rally in the first half of 2023. In fact, over the last four years the market has expended a lot of energy to end up in exactly the same place. The ASX is currently sitting at 6,838. In November of 2019 the ASX was slightly higher at 6,846.
Where to from here
What does the future have in store for investors? That is the question we all want answered. And market commentators love to make predictions. There is no downside. People who already agree with your prediction will bask in their own reflective wisdom. And people who disagree will still at least start to listen to you before retreating back into their ego coddling echo chamber. And the best part is that nobody will ever hold you to account because the next day you can make an entirely different prediction.
I’m not a market commentator. I’m just an individual investor. I don’t invest anyone else’s money unless you count my mother. And as a long-term investor I know there is little value in predictions about where the market will be in the next year. For many investors the best path forward is ignoring the noise and continuing to follow a long-term plan.
For other investors the high-level market conditions may play a role in their approach. I am certainly not advocating for market timing. If you are making decisions about investing today vs. tomorrow or this month vs. next month good luck. It is a coin flip.
What I am saying is that valuation levels should be an input into investment decision making. To make sure I focus on the bigger picture I like to bucket the market into overarching categories based on valuation levels. For me there are three different market environments:
Back up the truck
This is when the market is so cheap that I want to invest every dollar I have with the exception of my emergency fund. Figuring out when the market is in this phase is easier said than done. The market often looks cheap in retrospect. At the time it is likely that earnings are also falling which means the market doesn’t look cheap using relative valuation measures like price to earnings.
The other challenge is that the market is likely cheap because the economic environment is terrible and investor sentiment is negative. It is hard to go against the grain. And even for investors who have the fortitude to go against the herd it can be hard to figure out an entry point since the expectation is that market will keep dropping. I ran into this problem during COVID where I was ready to buy but thought the market would keep dropping. I got greedy for lower prices.
Nothing to see here
This is where we find the market most of the time. The market isn’t overly cheap and it isn’t overly expensive. This is where you stick to your plan and investment strategy. For most working age investors this means investing regularly which is the best pathway to build wealth over the long-term.
This is when your Uber driver is giving you investment tips and high schoolers skip class to day trade. Bubbles are clearer in retrospect but like a severely undervalued market it can be hard to identify at the time. There will be a narrative attached to the surge in prices. With some perspective we can look back and see that the narrative was simply justifying irrationality. But it seems hypnotically compelling at the time. Especially because investors want it to be true.
This is a time when investors may want to build up some cash. A share that has appreciated and may be overvalued does not necessarily mean it is time to sell given potential tax consequences and the fact that you may simply be wrong. I’ve addressed this topic in my article when to sell shares. Yet there are other ways of raising cash. New savings can be directed towards cash instead of the share market. Dividends can be retained instead of reinvested.
How does the market look from a relative valuation perspective
There is no correct answer. There are however two techniques that investors typically use when assessing valuation levels. The first technique is using relative valuation measures. A relative valuation measure is a financial ratio such as price to earnings (“P/E”). Other ratios such as price to sales or price to cash flow are also used.
A relative valuation measure is representative of how much investors are willing to pay for a dollar of earnings or sales or cash flow. The higher the ratios the more investors are willing to pay. One critical element of a relative valuation measure is that the number does not tell us anything. A P/E of 15 or 20 tells us nothing in isolation and we must focus on the ‘relative’. We need a point of comparison.
If the market is trading at a P/E of 15 and it traded at 20 times earnings last year we can say that the market is cheaper than it was a year ago. If the Australian market is trading at 10 times earnings and the US is at 20, we can say that the US market is more expensive than the Australian market. What a relative valuation measure cannot tell you is if the differences between two markets, two points in time or two different companies are justified.
There are many reasons why a market or a company would trade at a different valuation level. For instance, when comparing two points in time the level of interest rates would influence valuation levels. Expected growth rates between countries or companies will influence valuation levels. If earnings are expected to fall in the future valuations would be lower.
I like to use the cyclically adjusted price to earnings (“CAPE”) ratio as a relative valuation measure for the overall market. The CAPE ratio uses the average earnings from the past 10 years to smooth out the cyclicality of earnings.
According to data from Robert Shiller at Yale University the US is trading at a CAPE ratio of around 30 as of September 2023. That is down from a recent high in 2021 of 38 but higher than the low during the market fall in 2022 when the CAPE reached 27. Historically the CAPE ratio is still higher than average. The average monthly CAPE since 2000 has been 27.
In Australia the CAPE ratio on June 30th 2023 was around 19 based on data from Siblis Research. The publicly available data is less robust than the US but the CAPE has come down from 23 in 2021.
How does Morningstar view the market
As mentioned, there are limitations to relative valuation measures. Investors need to understand how the conditions of the overall economy and the particulars of an individual company impact the level of valuation as measured by something like the P/E ratio. In other words, a valuation measure that is billed as a short-cut requires significant analysis to be relevant in decision making.
This is why investment analysts typically resort to a discounted cash flow model. An analyst will estimate what a company will make in the future and discount those future cash flows back to the present day. That is an overly simplified explanation but you can learn more listening to this episode of our podcast Investing Compass.
The point of this approach is to estimate what a company is worth based on the specifics of that company and the external forces that will influence how the company performs. Our analysts estimate the fair value for the 1600 shares in our coverage universe. We can roll those valuation levels up to the country level and look at markets.
In Australia the price to fair value is .87 which is 13% undervalued. The only time the Australian market has been this cheap was during the pandemic and the GFC. The price to fair value for the companies we cover in the US is currently at .89 which means they are 11% undervalued. The US share market has only been this cheap 12% of the time since 2011.
Within the universe of shares that our analysts cover there are sectors and individual companies that are attractive and trading at larger discounts than the overall market. Our recent Q4 Australian Market Outlook takes a sector-by-sector view of shares trading on the ASX. Our monthly Global Equity Best Ideas report identifies our top picks across our global coverage universe.
How to categorise the current market
In reviewing these two sets of valuation data I think it is safe to say that markets are currently in my ‘nothing to see here’ range. This isn’t a bad place to be considering my view that we were in bubble territory in 2021. I wrote about that in a series of articles titled Bubbleville.
Where we go from here is anyone’s guess. Perhaps the rally in the first half of 2023 was simply an AI induced anomaly that impacted 7 large shares in the US. Maybe we will look back and view the first half of 2023 as a rally during an otherwise downward trend in markets.
We do need to remember that not all bubbles spectacularly pop and fall into the ‘back up the truck’ range. Sometimes they simply meander on until valuations become more reasonable.
Meandering on is not exactly what we want as investors because returns are often below average during these periods. They certainly have been since the end of 2021. And that is the issue with buying during bubble periods. There is very little margin for error when investor expectations are so high.
What should investors do right now
As the markets have come down I’ve changed my behaviour. I’m following my plan and strategy by putting new savings into the market and I’ve spent down some of the cash I built up when I thought we were in bubble territory. I’ve outlined what I’ve done and why in the following three articles:
People are always going to endlessly speculate about short-term market movements. As technology has advanced it has become easier to constantly check what the market is doing. It has also become easier to hear from so called experts who will tell you where the market is going in the days, weeks and months ahead.
Market noise may be hard to avoid. But this endless speculation on short-term movements doesn’t contribute at all to building wealth over the long-term. There is a lot of evidence that it detracts from investor outcomes. Having a general sense of the valuation level of the market is helpful. More helpful is the consistent discipline of savings and investing month after month, year after year and decade after decade. That is how to achieve your investing goals.
I want to hear about your view of markets right now. You can email me at email@example.com and I will send you Morningstar’s Q4 Aussie market outlook as a thank you.