HOW TO TELL IF THE JSE IS OVERVALUED

Are share prices on the lo­cal bourse on the verge of burst­ing?

Finweek English Edition - - FRONT PAGE - By Schalk Louw edi­to­rial@fin­week.co.za Schalk Louw is a port­fo­lio man­ager at PSG Wealth.

this past Easter Week­end, we were priv­i­leged enough to en­joy a Sun­day lunch with my par­ents at their re­tire­ment vil­lage. The din­ing hall was packed and we had barely ar­rived be­fore the first course made its ap­pear­ance. Shortly af­ter, we were pre­sented with the sec­ond course and then our main course mo­ments af­ter the pre­vi­ous one. I ini­tially found this speedy ser­vice very strange, but it started to make sense later that day. We can eas­ily fool our stom­achs into eat­ing more by feed­ing it fast enough, as there is a slight de­lay be­fore we re­alise that it is full. Teary-eyed, I man­aged to fin­ish my main course and while I was still try­ing to swal­low that last bite, I heard the wait­ress say: “And for dessert...” I con­vinced my­self that there was still enough room for desert and fin­ished it, only to end up moan­ing and groan­ing in dis­com­fort later that af­ter­noon, con­vinced that my stom­ach was on the verge of burst­ing.

About five to seven years ago, in­vestors world­wide were in­vited to in­vest, fol­low­ing what could be la­belled as the worst re­ces­sion of all time. Ob­vi­ously they were cau­tious and ar­ti­fi­cially low in­ter­est rates were used as an in­cen­tive, much like the sherry served prior to the meal at the re­tire­ment vil­lage. Slowly but surely in­vestors’ ap­petites for shares started to grow year-on-year. But with weak to neg­a­tive growth in share prices, and volatil­ity that has made its re­turn to the mar­ket this past year, the big ques­tion is whether share prices are still overfed, or more specif­i­cally, overvalued. How likely are they to burst?

When we take a look at the his­toric priceto-earn­ings ra­tio (P/E) on the FTSE/JSE All Share In­dex, 21.5 times, and take into con­sid­er­a­tion that the year-on-year growth on earn­ings on these shares amounted to -14.5%, it cer­tainly ap­pears so. The av­er­age re­turns on equity of the Top 20 largest shares on the ex­change are still around 17%, but when we place this in con­text by also men­tion­ing that the av­er­age for the last five years was around 19.3%, it def­i­nitely tells us that cau­tion must be ex­er­cised when tack­ling this meal.

Those who still doubt whether the mar­ket truly is overvalued may find the fol­low­ing in­di­ca­tors quite use­ful: 1. FTSE/JSE All Share In­dex Mar­ket Cap­i­tal­i­sa­tion/SA GDP ra­tio Although this in­di­ca­tor is used more suc­cess­fully on US mar­kets, it re­mains one of War­ren Buf­fett’s favourite in­di­ca­tors. This ra­tio doesn’t only show us that we are cur­rently trad­ing at even higher lev­els than be­fore the great cor­rec­tion of 2008, but also ap­prox­i­mately 62% higher than the last 15-year av­er­age. 2. Equity earn­ings yields ver­sus bond yields This in­di­ca­tor re­flects the rel­a­tive val­u­a­tion of our lo­cal stock mar­ket ver­sus the bond mar­ket. Bond rates have traded ap­prox­i­mately 2.5 per­cent­age points higher than the FTSE/ JSE All Share In­dex’s earn­ings yield over the past 15 years. At nearly 4.5 per­cent­age points higher, based on this ra­tio, we can see that lo­cal shares def­i­nitely ap­pear to be overfed at cur­rent lev­els. 3. Ex­pected P/E rel­a­tive to long-term av­er­age As I men­tioned ear­lier, his­tor­i­cal P/Es are def­i­nitely not trad­ing cheaply any­more. In­vestors who won­der how the an­a­lysts’ ex­pec­ta­tions in terms of growth in earn­ings will af­fect this ra­tio will find that the sit­u­a­tion re­mains quite dim. When we take a look at INET BFA con­sen­sus ex­pec­ta­tions, we’ll find that if this panel of an­a­lysts is cor­rect, that the P/E (sug­gest­ing that prices re­main at cur­rent lev­els) should fall to lev­els of around 19.5 times over the next 12 months. This is still 31% higher than the av­er­age P/E of 14.98 times over the last 15 years. Please re­mem­ber, though, that these find­ings are based on his­tor­i­cal data and it bears ab­so­lutely no prom­ise for fu­ture move­ments.

All I do know is that this mar­ket ap­pears to be overfed ac­cord­ing to sev­eral in­di­ca­tors, so if you want to save your­self the dis­com­fort that fol­lows overeat­ing, take proper mea­sures to en­sure that you are safe­guarded against any over­weight po­si­tions in shares.

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