A correction, not a bursting bubble

4.A correction not a bursting bubble

Garry Shilson-Josling, AAP Economist

Sydney

(Australian Associated Press)

When financial markets become chaotic it’s often instructive to look to the fundamentals for guidance.

Earnings, past and prospective, commodity and product price trends, inflation, interest rates, labour costs and the like.

You know, boring stuff that involves numbers.

The fundamentals don’t always provide a foolproof guide for investors in a market, of course.

You can bet that the market has got it wrong, but it could be quite a while – years, even – before you collect on your wager.

As the economics great John Maynard Keynes said: “Markets can remain irrational a lot longer than you and I can remain solvent”.

Even so, it’s good to have an idea of whether a fairly-valued market has just been hit by a bout of nerves unjustified by a sober assessment of the outlook; an overvalued market is undergoing a healthy, if somewhat painful “correction”; or a bubble inflated by irrational expectations is finally bursting.

The `healthy correction’ argument seems to have the most going for it.

In the past few months, share prices globally have been near their highest levels in a decade relative to projected earnings.

And that’s important, because a share is really nothing more than a claim on a share of a company’s future earnings.

The Reserve Bank of Australia’s website includes a collection of charts – it’s Chart Pack – updated monthly, and it includes an instructive chart of the ratio of current share prices to prospective earnings over the coming year, for both Australia and the world.

It’s a only rule of thumb.

There is a lot more to share valuations than earnings forecasts by analysts at stockbroking firms.

But if any single chart told the story of the market’s vulnerability to a sell-off it’s that one.

It shows prices in both Australia and the rest of the world nudging 17 times prospective earnings in recent months.

That ratio has not been higher for more than a decade, and over the past 20 years was only consistently above recent levels around the time of the infamous “tech stock” boom that pushed share prices into Fantasyland.

Assuming the earnings outlook is not downgraded, share prices needed to fall 12 to 18 per cent for the price/earnings ratio to get back to a more reasonable 14 to 15.

Both Australian and the world share markets have lost about 10 per cent so far this month.

So, from this perspective, while there may some more “correction” to come, it’s probably fair to say that we are more than half way to the point where further market falls would be hard to justify and begin to look like overshooting.

If the world economy takes a turn for the worse, so would fundamental estimates of fair value for markets and more downside could be justified.

But, right now, markets are a bit pricey rather than way out of line with reality.

It’s 2015, not 2000.

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