JSE: take some profits!

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South Africa’s perfect investment storm of slowing inflation, a stronger rand, higher inflation rates than in developed markets, an extremely successful SWC and, on top of it all, an invitation to join the BRIC countries, continues to lure foreign investors. So says Dr Prieur du Plessis, chairman of Plexus Asset Management and author of the Investment Postcards blog. “For the 12 months ended 31 December 2010 the JSE as measured by the FTSE/JSE All Share Index returned 33,0% in US dollars – double the MSCI Emerging Markets Index’s return of 16,4% and nearly 3,5 times the MSCI World Index’s 9,6%.”

Over the past quarter the South African equity market returned a staggering 15,1% in US dollars, income and dividends reinvested, significantly outpacing the MSCI World Index’s 8,6% and MSCI Emerging Markets’ 7,1%.

According to du Plessis, the million dollar question is: what about valuation? “From a fundamental point of view I prefer Prof Robert Shiller’s Cyclically Adjusted Price Earnings Ratio, or CAPE in short. It is an enhanced way of calculating the PE ratio that takes into account the average inflation-adjusted earnings over the past ten years and thereby smoothing the earnings fluctuations from year to year. CAPE is calculated by dividing the real stock index by the average real earnings over the past ten years,” he explains.

“Looking at the real earnings of the FTSE/JSE All Share Index it is amazing that over the past 18 years real earnings in down cycles always reverted to the 10-year average (see accompanying Graph A),” du Plessis points out.

The historical CAPE of the FTSE/JSE All Share Index over the past 18 years was 17,0. “It is frightening to see how expensive the South African equity market was from 2006 to 2008, only to revert to its historical average of approximately 17,0. The CAPE is currently 19,6 or 15% above the historical average, rendering the South African stock market somewhat expensive (see accompanying Graph B),” says du Plessis.

Du Plessis is quick to add that the problem with CAPE is that no one knows when the market will revert to its historical average. “If you base your investment decisions solely on CAPE you may be out of the market for a very long time, as happened from 2005 to 2008, and miss significant upside,” he says.

According to du Plessis the current PE ratio of the FTSE/JSE All Share Index of 17,2 is 30,3% higher than the historical average of 13,2 since 1982 and 15,4% higher than the average since end 2004 after the market rerated in terms of CAPE (see accompanying Graph C).

“It is evident that South African equity prices as measured by the FTSE/JSE All Share Index are discounting the earnings base to grow by 18% to 24% over the next 12 months,” says du Plessis. “The anticipation may be on the high side, especially with consumer spending under continued pressure, but it is not unachievable.

“My conclusion is that while there is still some upside in South African stocks, the market is extended. It is perhaps time to bank a few profits.”

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