Is the JSE a buy?

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Analysts the world over are grappling with the question: Are markets cheap or just fair value at the current levels? Investment analysts and portfolio managers use a myriad valuation tools to try to get to grips with this question. One of the most commonly used valuation tools is the so-called price-earnings (PE) ratio, which shows the relationship between the current price of a share (or market index) and its profit, or earnings. These earnings are based on what was reported in the financial statements for the most recent 12 months.

To calculate the PE ratio, one simply divides the share (or index) price by the most recent year’s headline earnings per share (or the total for all shares within a particular index). Based on those 12 months’ performance, one will know how many years to wait for the company to earn back what one is paying for the shares today. For instance, a PE ratio of 15 means it will be a decade and a half at the current profitability before one’s investment is “repaid” by the company.

An historical PE ratio, although an exact science, is a backward-looking valuation tool. What is far more important is trying to get a realistic valuation of the markets on a forward price-earnings basis, whereby analysts estimate what company earnings will be over the next year or two. Predicting the future profitability of a business is never easy, but when the economic environment is extremely uncertain, such as we are currently experiencing, this is virtually an impossible task.

Analysts are notoriously wrong with their forward-looking estimates even in more certain times. One of the most useful and predictive measures of stock market valuation is the cyclically adjusted price-earnings ratio (CAPE), or normalised earnings as it is more commonly known.

The CAPE ratio was created by Yale professor Robert Shiller, author of “Irrational Exuberance” and one of the world’s most respected economists. The normalised price-earnings (PE) ratio mutes the impact of the business cycle by averaging ten years of earnings. It thus provides a good picture of the market’s value regardless of where we are in the business cycle.

In a recent interview (24 February 2009) on Yahoo Finance, Tech Ticker, Professor Shiller reported that his PE ratio for the US market (as measured by the S&P 500) had just dropped to below 14. This is the first time in 15 years that the PE has dropped below the long-term average of 15. When asked whether he considered this to be a good buying opportunity, Professer Shiller’s answer was an emphatic “no”. He is waiting until the PE drops below 10, which it has done at major market lows in the past. That could happen either through an additional severe drop or a long period in which the market moves sideways and earnings grow again.

As far as the South African situation is concerned, researchers at Plexus Asset Management calculated the normalised PE ratio for the domestic stock market to determine whether or not the recent market correction has put local shares in bargain territory. The normalised PE ratio was calculated as the current price (index value) of the FTSE/JSE All Share Index divided by the rolling seven-year average historical earnings from December 1959 to the end of February 2009, therefore the first data point available is that on 31 December 1966 (see accompanying graph). Shiller used the rolling ten-year average for the US, but seven years fit our data better.

The results of the study by Plexus reveal that the current normalised PE stands at 14,9, while the average over the total period comes in at 17,1. The average normalised PE ratio at market lows was 11,4.

The average normalised PE at market lows was calculated from the turning points of all historical bear markets, including the current bear market up to the end of February 2009 (see accompanying table). The table also shows the total decline from the peak to the low of each bear market (and the current correction up to 28 February 2009).

The study shows that we are still some way off the average normalised PE ratio for market lows. Although one could argue that broadly speaking we are in buying territory, the market could still go lower and investors would be wise to tread with caution. One must bear in mind, however, that the study refers to the market as a whole and bargains are certainly already available through good stock picking. My advise to investors is to phase money into the market over the next few months rather than go in boots and all with a single lump sum.


Source: Plexus Asset Management based on data from I-net Bridge


Bear market to end of February 2009 (not necessarily turning point)

Source: Plexus Asset Management based on data from I-net Bridge


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