Is the Aussie stock market overvalued? Who knows?
I’ve been hearing lots of chatter about the stock market being overvalued in the last month or so. The All Ordinaries Index (All Ords) was touching 6,000 points between mid-March to mid-April. Had two weeks of big drops, down about 5%. As at mid-May, it is back to 5,700 points (note: The All Ords is a tracker to measure the share price of all the companies listed on the ASX).
Near 6,000 points is a 7 year high for the All Ords. In the last 10 years, the last time the index reached this level the GFC followed. So, it does make sense that people are starting to talk about overvaluation.
As we are about to launch a new product, this question is very important to us. BetterWealth will advise customers to invest part of their wealth into the Aussie stock market. The size of that investment allocation will depend on each customer.
If the market is actually overvalued, it is likely to have a “correction” - a fancy word for price fall. Then our customers would instantly "lose money" as soon as they use our product. Not the best scenario for the investors. Not the best way to start a business.
But in reality, a fall in the market is only paper loss. For long term investors, short term price changes doesn’t mean much - unless you have borrowed to invest. The real question is the value when you sell out. At BetterWealth, we are committed to building wealth for the long term. So we can get comfortable with short term price drops.
How to measure value? P/E Ratio
Whilst the index price is one point to reference, the better way to think about the market valuation is to look at the P/E Ratio. The All Ords is currently trading at a P/E Ratio of 14.3x. Investors are paying $14.30 (in share price) for every dollar of profit made by the companies listed on the ASX. The higher the P/E Ratio, the more expensive the company.
On a P/E Ratio basis, the Aussie market is 10% more expensive than the 10 year average. Apart from the great times before the GFC, the market was this expensive for only 2 periods in the last 10 years:
- 1st Quarter of 2011: Followed by a fall in the market of 17% from Jan 2011 to Aug 2011
- 1st Quarter of 2013: Followed by the market continuing to go up - reaching the current highs. From April 2013, when P/E Ratio reached 15.9x, the market has gone up by 18%.
What does it mean?
6,000 points and a P/E Ratio of 10% higher than the 10 year average does suggest some overvaluation. But, this can all change when companies release their most recent profit results. If they report good numbers, the P/E Ratio will come down and the market is no longer be expensive. That is what happened between 2013 to now.
As always, no one really knows if the market is going up or down, let alone anyone who can tell you when it will peak and bottom out. Legendary investor Peter Lynch admitted to as much:
“It would be wonderful if we could avoid the setbacks with timely exits, but nobody has figured out how to predict them”
At BetterWealth, we are in it to grow wealth for the long term. Short term price changes are part and parcel of investing. As Warren Buffet said “over the long term, the stock market news will be good”.
If you prefer the stock picking and market timing approach, good luck. I’m interested to see what fund managers and experts were saying in 1st Quarter of 2011 vs the 1st Quarter of 2013. Did they pick the top and the bottom?