Wednesday, 21 April 2010

Australian (ASX 200) stock market including the cyclically adjusted price earnings ratio (PE10 or CAPE) – April 2010 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted PE ratio (known as the PE10 or CAPE) for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller for the S&P 500. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 = 26 and will own 30% more stocks when the ASX 200 PE10 = 6.

Chart 1 plots the ASX 200 PE10. Key points this month are:

ASX 200 PE10 = 19.3 which is up from 19.0 last month. My target Australian Equities target is now 19.0% which is down from 19.1% last month.

ASX 200 PE10 Average = 22.8. This would imply the market today is 16% undervalued using this measure. I am concerned about this as my dataset is quite young dating only from 1993 and so may not have enough history built into it. If I look at the S&P 500 data set since 1993 its PE10 average has been 22.5 which is very similar to the ASX 200 PE10, yet since 1881 has been a much reduced 16.4. If we assumed that the ASX 200 also dated back to 1881 could it also have been around 16.4 implying an overvaluation today of 17%?

ASX 200 PE10 20 Percentile = 17.4 up from 17.3 last month

ASX 200 PE10 80 Percentile = 27.7 which is up from 27.6 last month

ASX 200 PE10 Correlation with Real ASX 200 Price = 0.80 which is down from 0.81

Chart 2 plots further reinforces why I am using this method. While the R^2 is low at 0.1579 there appears to be a trend suggesting that the return in the following year is dependent on the ASX 200 PE10 value. Using the trend line with a PE10 of 19.3 results in a 1 year expected earnings projection of 12.7%. The correlation of the data in chart 2 is -0.40 up from -0.39 last month.

Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends and Earnings both remain below the trend line but have now both started rising again since the lows in February 2010. Earnings have also started to depart from Dividends which means companies are now starting to retain some profits for investment in future business growth.

As always DYOR.

Assumptions include:
- All historic figures are taken from official data from the Reserve Bank of Australia.
- April 2010 price is the 21 April 2010 market close of 4954.3.
- April 2010 Earnings and Dividends are assumed to be the same as the March numbers.
- Inflation data from January, February, March and April 2010 are estimated.

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