Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 207

High or low price, future returns will be low

The higher the price you pay, the lower your returns. This is a fundamental truth of investing, a law, like gravity, and an impost that cannot be escaped. And yet it is always the case that when future returns are the least attractive, enthusiasm for assets is highest. The dichotomy is best explained by author and economist John Kenneth Galbraith’s definition of a bubble at the beginning of section VII of his 1955 book, The Great Crash 1929:

“At some point in the growth of a boom all aspects of property ownership become irrelevant except for the prospect of an early rise in price. Income from the property, or enjoyment of its use, or even its long run worth is now academic … What is important is that tomorrow or next week market values will rise – as they did yesterday or last week – and a profit can be realised.”

It is when the present value of a future income stream (intrinsic value) is ignored and ‘investing’ is replaced with uninformed speculation about (unjustified) price increases that we should be most concerned.

The conventional understanding of risk is that higher returns require the adoption of higher risks. But when share prices are low, as they were at the bottom of the GFC in late 2008, real risk is relatively low. It’s only the perception of risk that is high.

To complete the circle, I note that Seth Klarman from Baupost Group recently observed:

“When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

Risk today, and why this time is not different

It’s worth putting some numbers around the extent of risks in the market today. While many may respond by suggesting low interest rates justify the numbers, let’s remember that this time is never different. The following chart reveals the S&P/ASX100 is now at its greatest premium, above our intrinsic value estimate, in a decade. This alone suggests that a dose of caution is warranted.

Indicative premium to intrinsic value S&P/ASX100 ex-resources

Source: Montgomery Investment Management Pty Limited

The next chart plots the Cyclically Adjusted Price/Earnings (CAPE) Ratio for the US market, using data from Robert Shiller’s website. This time series goes back to the late 1800s, and being based on 10-year inflation-adjusted trailing average earnings, it removes some cyclical ‘noise’.

Shiller CAPE Ratio S&P500

It also shows a market that looks expensive. Only twice since 1881 has the Shiller CAPE been above the current level; the first time just prior to the Great Depression, and the second time just prior to the Tech Wreck.

What about Jeremy Grantham’s ‘new plateau’ statement?

Jeremy Grantham, of GMO fame, recently looked at the S&P500’s PE ratio and proffered the suggestion that this time is indeed different: “very, very different.” A close examination reveals the appearance of a regime change. Between 1970 and 1997, the PE averaged 13.95, but since 1997 the average PE has been 23.36 with higher highs and higher lows being recorded than the pre-1997 period.

In the Shiller CAPE chart above, prior to 1994, a PE above 20 looked to have been the level at which valuation became a concern, with the market mean-reverting and then trading below that level almost 90% of the time.

Since 1994, however, things have been different. In fact, during the post-1994 period the CAPE has been above 20 times for more than 90% of the time. Even in the depths of the GFC, it did not approach the low points seen regularly during the earlier period, and barely recorded any time below its longer-term average.

Grantham’s regime change suggests that we might have a new average – one drawn from the data since 1994 or 1997 – depending on which version of the PE is used – and one that is much higher than any drawn from taking into account the entire period. Such a conclusion is tantamount to what might be described as a new ‘permanently high plateau’. If that expression sounds familiar, it is because the last person who said it was Yale economist Professor Irving Fisher.

It was October 17, 1929 in the New York Times that Fisher wrote;

“Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon, if ever, a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months.”

That was October 17. Black Thursday occurred on October 24, and the market dropped by 11%, followed four days later by Black Monday, when it fell another 13%, and the next day, Black Tuesday, it lost a further 12%.

As an aside, Fisher was back at it again on November 14, 1929 suggesting:

“The end of the decline of the stockmarket will probably not be long, only a few more days at most.”

As we end financial year 2016/2017, where is Australia?

I am not suggesting we are headed for anything like the circumstances during the Great Depression. I am suggesting that current valuations in Australia are not justified by near-term economic conditions, and more importantly, prospects for profit growth. It does not follow that overvaluation is immediately followed by a crash. However, flying in the face of conventional wisdom, it pays to be more cautious because real risks are higher than perceived risks.

Forward P/E ratio, ASX200 excluding banks and resource companies

This chart shows at the end of May 2017, the average PE for the group of Australian companies mapped was 18 times. Worryingly, growth in forecast earnings has contributed just 19% of the appreciation in stock prices over the last five years. Fully 81% of the market’s performance over the last five years has simply been due to PE expansion, that is, investors’ willingness to pay more for the same dollar of profits. If the outlook for longer-term earnings growth has improved materially over the same period, such optimism might be warranted. However, like many of our wealthy and experienced business and entrepreneur clients, we see darker tinges to the clouds forming on the horizon.

The average PE today is 7% higher than at the end of October 2007, the pre-GFC peak. Additionally, there are parallels to that period with global interest rates starting to rise following a period of aggressively accommodative monetary policy, and record high levels of debt in the Australian household sector.

The big difference for Australia this time however is that a slowing China, and contracting investment in resources sector capacity growth, will fail to rescue the Australian economy from any broader economic slowdown.

Prior to the GFC, forecast earnings growth was 10% higher than the prior corresponding period, underpinning the PE ratios investors were willing to pay. Today, not only is the market paying 7% more for each dollar of earnings than it was prior to the GFC, but earnings forecasts are only 3% higher than the same time a year ago.

It follows that caution may well be premature but it is nevertheless well founded because the higher the price you pay, the lower your returns and locking in low returns is in nobody’s interest.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

RELATED ARTICLES

Feel the fear and buy anyway

Redefining risk for income investors

Should you be a value or growth investor?

banner

Most viewed in recent weeks

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are franking credits worth pursuing?

Are franking credits factored into share prices? The data suggests they're probably not, and there are certain types of stocks that offer higher franking credits as well as the prospect for higher returns.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Latest Updates

A nation of landlords and fund managers

Super and housing dwarf every other asset class in Australia, and they’ve both become too big to fail. Can they continue to grow at current rates, and if so, what are the implications for the economy, work and markets?

Economy

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Retirement

Retiring debt-free may not be the best strategy

Retiring with debt may have advantages. Maintaining a mortgage on the family home can provide a line of credit in retirement for flexibility, extra income, and a DIY reverse mortgage strategy.

Shares

Why the ASX is losing Its best companies

The ASX is shrinking not by accident, but by design. A governance model that rewards detachment over ownership is driving capital into private hands and weakening public markets.

Investment strategies

3 reasons the party in big tech stocks may be over

The AI boom has sparked investor euphoria, but under the surface, US big tech is showing cracks - slowing growth, surging capex, and fading dominance signal it's time to question conventional tech optimism.

Investment strategies

Resilience is the new alpha

Trade is now a strategic weapon, reshaping the investment landscape. In this environment, resilient companies - those capable of absorbing shocks and defending margins - are best positioned to outperform.

Shares

The DNA of long-term compounding machines

The next generation of wealth creation is likely to emerge from founder influenced firms that combine scalable models with long-term alignment. Four signs can alert investors to these companies before the crowds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.