Sunday 29 April 2007

Dow and All Ords to Rise 25%

With the US and Australian stock markets at, or near, all time highs, many pundits are predicting an imminent plunge. The fact of the matter is that the market will always be hitting "all time highs" as it follows its long-term uptrend over the centuries. The question is whether or not a particular high is associated with the excessive exuberance, or if it is supported by fundamental values, profitability and projected continued economic growth.

Alan Kohler had an interesting article outlining the case for viewing current market levels as reasonable, and even provides a rationale for a further gain of 25% or more in the next couple of years:

In 1987 the trailing price-earnings ratio of the Australian market was 20.4, which produces an earnings yield of 4.9 per cent. The 10-year bond yield was then 12.5 per cent. Today the earnings yield is 6.4 per cent and the bond yield 5.9 per cent.

As we stand here with the Dow at 13,000 and the ASX S&P 200 at 6150, shares are cheap.

It is now equivalent to about December 1986. History never repeats itself exactly of course, but if it did, the Australian index would hit 13,000 next January - before crashing spectacularly.

The point is that the sharemarket has not yet had the price-earnings multiple "blow-off" that usually marks the end of the bull market.

The 1987 blow-off took the average P/E ratio to only 20.4 because inflation was 8.5 per cent and the bond yield was 12.5 per cent - more than double what it is now. But that P/E was double the then 10-year average.

Now the trailing P/E is 18 times, but inflation is 2.7 per cent and the bond yield 5.9 per cent (3.2 per cent real versus 4 per cent real in 1987). Times change, but in my view people do not. At the end of a long bull market, with abundant cash and rampant optimism, people tend to go nuts. They start extrapolating existing growth forever and price assets accordingly.

So far that has not happened: share prices have merely kept pace with earnings as they are now, not what optimistic forecasters think they might be.

While I don't necessarily think Alan is right, it's nice to read that your stock market portfolio could increase another 25% by the end of next year. Of course, if it did increase that much, I'd be even more tempted to abandon my long-term asset allocation and lighten up on my stock holdings in an attempt to "time the market". The only justification for such a radical change of investment strategy would be that having experienced many years of exceptionally high growth, my net worth would be well above where I need to be to attain my retirement and investment performance targets, so I could shift to a lower-risk, lower-return asset mix and have greater certainty of reaching my original goals. The alternative would be to stick with my original asset allocations, and hope that the returns reverted to average performance which would result in my final outcome exceeding my initial expectations.

Enough Wealth

1 comment:

Adventures In Money Making said...

someone else mentioned that the dow was likely to rise 17% this year.

nice. but not nice enough if the dollar slide 15%!!!