Unconventional wisdom: Will the Australian market outperform the US?
Making trade-offs between two different markets.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Will the Australian market outperform the US?
“Beauty is bought by judgement of the eye.”
― William Shakespeare
Last week I explored Professor Javier Estrada’s work outlining the three drivers of share market returns and the prospects for the US share market going forward. As a reminder the three drivers are dividends, changes in valuation and earnings growth.
It is worth reading the first article as it forms a foundation for applying Professor Estrada’s approach to the Australian market.
Prospects for the Aussie market
Available historical data is less robust in Australia. That doesn’t mean I can’t approximate the same exercise for the ASX 200 by looking at the dividend yield, earnings growth rate and P/E ratio to compare today’s market with historical figures.
Over the past 20 years the average P/E ratio for the ASX 200 was 14.77. The 10-year average is similar at 16.36. Currently the P/E ratio is 20.53.
Recent earnings growth for the ASX 200 averages 2.80% annually over the past decade.
The current dividend yield is low for Australian standards at 3.10%. Over the past decade the average dividend yield was 4.40%.
Given the greater role dividends play in Australian returns it is worth exploring a key assumption Professor Estrada made in his paper. His model assumes dividend levels don’t change. Whatever the dividend is at the time of running the model gets applied going forward. The assumption is that dividends don’t change.
In the real-world dividends do change. This adds to returns if they go up and reduces returns if they go down. This matters less in the US where the dividend yield is lower and more in Australia where it is higher. This doesn’t invalidate the exercise but it is something to consider when interpreting the results.
Using the same approach as Professor Estrada I’ve mapped out potential scenarios for the Australian market.
One thing to note is that I have not included any benefit from franking credits. Historically franking credits have added approximately 2% annually to returns in Australia.
If the earnings growth over the previous 10 years continues and valuation levels remain consistent Australian investors would receive ASX 200 returns in the low 5% range not including franking credits. These are similar levels to the US market given static valuation level and historic earnings growth.
Looking at the differences between the US and Australian market can uncover lessons no matter what direction markets take. The following chart will form the basis for the rest of the article. It should be noted that the historical US data goes back to 1871 and the Australian data is shorter-term.
Does the US or Australia represent a better opportunity for investors?
Too many people want you to believe that investing is a deterministic exercise. That is a model where for each input, a predictable output emerges. A calculator is deterministic.
Investing is probabilistic. There are a range of possible outcomes for every input. There may be different probabilities for different outcomes but there is no certain answer.
To make decisions in a probabilistic environment we make trade-offs using history, data, intuition, systems and tools like diversification. We continually do this to try and set ourselves up for the outcome we desire.
Since all of us desire different outcomes the decisions that each of us make will, and should, be different. The good news is that we don’t have to pick between the Australian or US market. We can invest in both along with the rest of the globe. We can also make the trade-offs that best suit our situation.
The growth / valuation trade-off
The US market is trading at a P/E level that is higher than Australia. A simplistic assessment of the two markets would indicate that the Australian market is a comparative bargain. However, the P/E ratio is a relative valuation measure. It is a mechanism to compare one share / market to another or one point in time to another. It does not provide an absolute valuation which allows an investor to declare a share or market cheap in isolation of comparative data points.
An absolute valuation measure is an attempt at figuring out the intrinsic value of an investment. This is what our analysts do for shares in their coverage universe. Rolling up the price to fair value of individual shares provides a view of the overall market. For reference the Australian market is currently 10% overvalued and the US market is 1% overvalued.
In theory this makes an absolute valuation measure preferrable but only if you have confidence that it approximates the value of the share or market. You should not underestimate how hard it is to do this.
Using a relative valuation measure to make a decision requires context. For instance, assuming the historical growth rate of the ASX 200 and S&P 500 continues - is it worth paying 27 times earnings for the US market given a higher growth rate than the Aussie market?
There isn’t a definitive way to make this call but the answer may be different for different investors. For a young investor with a 30-year timeline earnings growth may be more attractive. Assuming the same growth rates in each country continue for 30 years $1 in earnings for the S&P 500 would be worth $3.44 vs. $2.29 for the ASX 200.
US earnings would be 115% higher which means if valuation levels don’t change the US return would be 244% vs 129% for Australia over 30 years.
Dividends / growth trade-off
For an investor with a shorter time frame and / or a different goal like generating income the differences in earnings growth may not matter as much.
For a group of companies like those represented by the S&P 500 or ASX 200 growing earnings is a function of making profitable investments in the underlying business. This could include more marketing, research & development or hiring more people.
The attractiveness of re-investing profits to grow earnings is company dependent on the company. Some companies have a long runway of growth and should invest as much as possible. Some companies don’t have good growth prospects and a more generous dividend policy should reflect that. In aggregate, earnings growth should be slower as more earnings are paid out in dividends.
With this context it makes sense that Australia has lower historical earnings growth and higher dividends compared to the US. This may be important to you or may not. What ultimately matters is what you are trying to accomplish.
If you have a 10-year time horizon and assume dividends remain steady like Professor Estrada the Australian market will deliver 138% more income than the US market. Franking credits would further that advantage. Depending upon your goals the extra income may trump additional capital growth.
If you are an income investor just remember that Professor Estrada did not account for dividend growth. The only way to get income growth is from earnings growth. I’m an income investor and far more of my portfolio is invested in the US because I’m willing to trade dividend growth for current yield.
Final thoughts
We strive for certainty in our lives and portfolios. We want some report or piece of data or guru to serve as a crystal ball for what we should do with our money.
Breaking down share market returns into the core drivers is helpful to clarify your thinking – but it doesn’t supply an answer. Nobody knows what valuation levels will do in the future or how fast earnings will grow or what will happen with dividends.
Investing is about accepting the risk of the unknown. That can be scary but it is also why the rewards from investing can be so great.
To get your share of those rewards requires you to educate yourself, figure out what you want and devise a plan to get there. All it takes after that is some patience while the world franticly and fruitlessly tries to predict what is around each corner.
If you want to make trade-offs with individual Aussie shares I’ve created a spreadsheet which lists every Aussie and NZ share in our coverage universe. This spreadsheet can be used to explore returns over the next decade based on earnings growth and P/E changes.
Email me and I will send it along – for those that have read Invest Your Way I would appreciate it if you could put a review and rating on Amazon, Goodreads or Booktopia in exchange for the spreadsheet. Thanks in advance.
Email me at [email protected].
After 51 consecutive weeks of publishing Unconventional Wisdom this will be the last installment until the 5th of January. I’m off to Nepal and Hong Kong for Christmas and New Years. I really appreciate everyone’s support this year. I hope readers have found these articles useful. Happy New Year!
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Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
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What I’ve been eating
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