JSE: How much is the price now?

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The fact that the global economy has entered a recession can no longer be disputed. And although the credit crisis in mainly the First World is the root cause of this recession, the fact that countries without exposure to the credit crisis, such as South Africa, will not be left unscathed is also no longer disputed.

The fact of the matter is that across the globe, businesses are experiencing a serious decline in earnings. But by how much will company earnings in South Africa decline, and how much of this bad news is already reflected in share prices?

In order to try to answer this question, there are two market theories that should be taken into account. Firstly, the theory of mean reversion, which is the commonly accepted theory that stock market valuations (or price levels) will always return to their 150% long-term averages, despite fluctuations above and below the average value.

The second is the fact that stock markets are forward-looking, which means that share prices discount what investors expect the economy and subsequently company earnings to do in future. If investors expect company earnings to change in future, share prices will move before the actual earnings numbers are reported. This price movement is reflected in the price earnings ratio (PE) of a share. For example, if investors accept that an average price earnings (PE) ratio of 10 for a particular company is fair (i.e. headline earnings of R10 over the last year and a current share price of R100), but they expect the company’s earnings to go down to R9 over the next year, then the price should go down to R90 to ensure a forward PE of 10 (i.e. R90/R9). However, as the price decline occurs before the lower earnings numbers are reported, the current PE (based on the last year’s headline earnings, which remain at R10) declines to 9 (i.e. R90/R10).

To determine by how much current stock market index levels are discounting future earnings prospects, one can compare the current price earnings (PE) ratio of the JSE to the long-term average (which reflects fair value). A study by Plexus Asset Management puts the long-term average PE for the FTSE/JSE All Share Index at 11,7 and the FTSE/JSE Financial and Industrial Index at 11,6. The current PEs for these indices stand at 8,4 and 8,3 respectively.

The fact that the current PE ratios are lower than their long-term averages means that investors are expecting earnings to decline going forward. The earnings in respect of these two indices have only declined by 3,9% and 5,6% respectively from their recent peaks to the current levels, but the PE ratios have come down much more than this due to the fact that the index levels have fallen by significantly more.

For the PE ratios to revert to their long-term averages or fair value, earnings will have to decline by a further 28,2% in respect of the All Share Index and a further 28,7% in respect of the Financial and Industrial Index. If the expected further decline in earnings materialises, the total decline in earnings from peak to trough will come in at -31,1% for the All Share and -32,7% for the Financial and Industrial Index.

Just how bad is this expected decline in earnings? To put it in perspective, the accompanying table shows all actual historical declining earnings cycles (from peak to trough) since 1960. Local share prices are already discounting a significant decline in company earnings going forward. And if this does materialise, it will be the worst decline since 1960.

Only time will tell whether or not this scenario will materialise. Although caution is still the operative word, the market is in bargain territory and investors should consider making use of this opportunity by phasing money into equities.

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