Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 33

Expect disappointment as values become stretched

It has been a good year in the Australian equity market. As we come to the end of the September 2013 quarter, the ASX300 Accumulation Index has increased by 24% over 12 months - a rate that is more than double the long term annual average of about 11%.

A natural response for many investors is to feel that they should allocate more capital to the market, to avoid missing out on the gains others are enjoying, and this is certainly a mindset that we have noticed recently. With short-term interest rates at record lows, there is no shortage of people who have become frustrated with the returns on cash, and are electing to move money into equities as their term deposits mature.

Don't abandon a disciplined approach

However, this line of thought often leads to decisions that are contrary to those a disciplined investment process would follow. When share prices are rising faster than corporate earnings, it is almost certain that the value available in the market is declining, and ultimately, value is a crucial driver of long term investment performance.

Not surprisingly, an analysis of historical returns shows that when the ASX Index has an unusually good year, the following year is more likely to be below average. This doesn’t always happen of course, but a good run last year is usually a sign that the odds have shifted against you. Our analyses suggest that when the market has performed as well as it has over the past year, the prospects for the year ahead are perhaps 1% dimmer than the 11% average.

When quickly-rising share prices get ahead of underlying values, we may be able to improve our assessment of future prospects if we ignore the share price and try to understand where underlying value sits. If the valuations were very good to begin with, then a year of rising prices may be no cause for alarm.

There are a couple of simple measures that we can look to in assessing value for the market as a whole. In the Australian market, historical analysis indicates that average P/E multiples and dividend yields have provided a useful aggregate value benchmark and an indicator of future return prospects. Let’s consider each of these.

In the case of dividend yields, the average for the All Ordinaries over several decades is around 4%, based on IRESS data. Currently the market sits quite close to this level, at around 4.1%, so on this measure, prospects for the year ahead are no less favourable than they might normally be. However, recall that investors have been demanding yield in recent times, and in many cases boards of directors have responded with increased payout ratios. Dividend yield may not be an accurate reflection of the underlying earnings capacity of the businesses, and it may be wise to be cautious in using it as a yardstick for value.

Potential for disappoinment

Turning to P/E ratios, the long run average for the All Ordinaries (again, based on IRESS data) lies at around 15x. Currently, the market sits at 17x, some 10-15% higher. This suggests that following the strong run recently, the market may now have moved to the slightly expensive side. At this level, our analysis indicates that the prospects for the year ahead may be around 2% less favourable than the 11% norm.

These reductions of 1-2% per year may seem small, and well worth accepting in the context of cash rates that are sitting close to the rate of inflation – and we’d probably have to agree with that. The real question is whether equities offer a sufficient risk premium. If the market offered reasonable value at the start of the recent run, it may have some way to go before pricing becomes a significant issue.

However, if the market continues to perform strongly, it will almost certainly be sowing the seeds for disappointment some way down the track, and investors need to guard against becoming ever more positive as valuations become increasingly tenuous.

Investors tend to manage their exposure to equities with one eye in the rear view mirror, and this has a significant impact on their investment returns over the long run. The effect of systematically investing more when the market has become expensive, and less when the market has become cheap, can bake in a level of underperformance that compounds over time.

Having a disciplined approach to valuation, and selling shares when the crowd is cheering them on can be very difficult to do – but in the long run the benefits are real.

 

Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller, ‘Value.able‘.

 


 

Leave a Comment:

RELATED ARTICLES

Behavioural reasons why we ignore life annuities

'FOMO' is driving residential property prices, not yields

Invest like Buffett? Diversification, Part 2

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

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.

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Latest Updates

Economy

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.

Investing

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.

Property

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Shares

ASX reporting season: Room for optimism

Despite mixed ASX results, the market has shown surprising resilience. With rate cuts ahead and economic conditions improving, investors should look beyond short-term noise and position for a potential cyclical upswing.

Property

A Bunnings play without the hefty price tag

BWT Trust has moved to bring management in house. Meanwhile, many of the properties it leases to Bunnings have been repriced to materially higher rents. This has removed two of the key 'snags' holding back the stock.

Investment strategies

Replacing bank hybrids with something similar

With APRA phasing out bank hybrids from 2027, investors must reassess these complex instruments. A synthetic hybrid strategy may offer similar returns but with greater control and clearer understanding of risks.

Shares

Nvidia's CEO is selling. Here's why Aussie investors should care

The magnitude of founder Jensen Huang’s selldown may seem small, but the signal is hard to ignore. When the person with the clearest insight into the company’s future starts cashing out, it’s worth asking why.

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.