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Anyone watching financial markets throughout January might be forgiven for being a little startled. The S&P/ASX 200 is now off 8% from its 4 January 2022 high, as is the S&P 500, and the MSCI All Country World is off 9%.

In this article, we’ll assess why, and provide some indicators on where to from here.

The pandemic response led to valuation expansion…

Firstly, let’s back up 2 years to when the world was just starting to learn about a little virus that sounded like the cousin of SARS. Borders slammed shut, holidays were cancelled, and markets sold off 30% before rebounding to the most aggressive bull market – trough to peak – we’ve seen.

This increase was a result of rapid and widespread stimulus from central banks that gave consumers money to spend on businesses such as home improvement. On the other hand, central banks slashed interest rates to near zero, making fixed interest unattractive, forcing money into higher risk assets such as stocks. Central banks have also been buying (primarily government) bonds this whole time, which has the effect of both providing a floor under the price of bonds (and hence keeping yields low and money in equities) and pumps liquidity into the market, which needs to be invested somewhere.

Which is currently being undone

The reason for the current sells off, is that all of that is starting to come undone.

Central banks are talking about (or have already started) reducing or ceasing their bond buying programs. Most are talking about raising interest rates either this year or next in response to increasing inflation (which is itself a consequence of all the stimulus and money printing). And for the most part, stimulus has largely dried up.

Therefore, without the intervention in the bond market, bonds are free to sell off to market prices, increasing yields, attracting money out of equity markets. Higher central bank interest rates will impact valuations, as the cash rate is a key input into the discount rates used in calculating company valuations. Less stimulus, while probably having the least impact, means the extra spending occurring on the government’s profit and loss is no longer going into businesses.

market image

The Market Price to Earnings Multiple

The Australian market has been trading above its 20-year average price to earnings (P/E) since about 2014. The Market P/E is simply the aggregate of all market caps in the ASX200 divided by the aggregate earnings (in the same way you would calculate the P/E for a company). The covid crash of March 2020 sent it briefly below the average before the above-mentioned factors and anticipation of a rapid economic recovery sent it rocketing higher. The market P/E has been declining through 2021 due to increasing earnings (as opposed increasing stock prices alone), however, it has continued to fall through January precisely due to price.

All this means that prices, relative to the earnings the companies are expected to produce this year, are getting cheaper.

Therefore, if valuations are becoming more attractive, is it time to buy?

The answer is a clear, definitive maybe.

Valuations have come back to the level the market was immediately prior to the March 2020 covid crash. P/Es had been expanding rapidly already so in February 2020 the market already felt somewhat overvalued. And we have only now just returned to below this level. The S&P/ASX 200, at 6969 points, is on a 17.4x forward price to earnings. This is still one standard deviation higher than the 20-year average.

One of the key reasons why it remains high relative to historical prices is that interest rates remain low historically, as discussed above. While there is no economic law that states “when interest rates are x, the market price to earnings will be y”, there is a correlation between interest rates and valuations.

What do we take away from this?

The current sell off has certainly already provided some attractive buying opportunities, especially in the higher P/E, higher growth companies. These are the stocks that have had the most price to earning expansion-led share price growth and therefore had more to lose when P/Es contracted again. Nevertheless, P/E multiples remain elevated compared to the last 2 decades. The market is already pricing in (read: expecting) some rate rises in the next year or 2, but if rates fire north of, say, 3%, there is still a long way for price to earnings and share prices to fall.

Rather than ending on such a dour note, I’ll finish by saying that 3% interest rates are likely to be still years away. Even if inflation continues to rise, 3% interest rates (compared to 0.1%) would have hugely negative consequences for our government’s interest bill and fiscal budget. And it would be detrimental to the banking sector, as many mortgages entered at such low rates may become unaffordable for those at the margin.

It’s not a time to panic, there are several attractive investing opportunities beginning to present themselves to the brave investor.

Luke Durbin
Written by Luke Durbin
Portfolio Manager
Oracle Investment Management

If you wish to discuss the current market further, talk to financial adviser today

Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
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