Wakefield Sykes

Thank you for your most interesting and penetrating article I will be fascinated to see SO’s response.I suspect it will probably include some reference to the impact of low interest rates on PE’s which I guess is a version of “this time it’s different” Nevertheless the decline in earnings of ASX companies in recent history is a real and disturbing fact Presumably, on this analysis, you would have zero exposure to equities!

Vishal Teckchandani

A fascinating read!

Shane Oliver

Thanks Chris for your detailed and thoughtful comments. I was trying to make general comments about investing rather than get into a debate about whether March or now was an extreme and what that may or may not mean for timing markets. Of course this debate is a complicated one depending on whether you look at PEs or adjust for low interest rates. I would tend to favour the latter as the level of interest rates can’t be ignored when making comparisons to other assets. Regarding dividends and compounding I did make the point that the returns in point #1 allow for the reinvestment of dividends and interest rates along the way. I think you are right in highlighting that I should have made more of the need to reinvest dividends and how that is key to getting a superior return from shares over long periods. My constraint was that I had run out of space given a self imposed limit! It's true that dividends have accounted for around half the compounded return from the Australian share market over long periods. It's also true as I note that the collapse in interest rates and earnings yields mean as I noted that “the returns seen over the last 120 years will likely be a lot lower over the next decade”. So just as cash and bond returns will be lower than they have been so too will equity returns…but as I point out shares should still be able to outperform bonds (with 10 year bond yields now 0.75% given last week's fall in yield) on a ten year horizon. That of course does not mean that there won’t be extreme swings in markets along the way!

Chris Leithner

Hi Wakefield Thanks for your comment. Over the past 20 years, Leithner & Co.’s portfolio’s allocation to equities has always been lighter than most others’ – but it’s never been close to zero. To conclude that the All Ords has reached an extreme doesn’t mean that each and every one of its 500 of its components has. Also, nobody (including me) knows for sure. Hence it seems to me that some variant of Ben Graham’s 25%-75% rule (a portfolio of stocks and bonds whose allocations don’t breach these minima and maxima) is sensible. Chris

Chris Leithner

Hi Shane Thanks for your response. I certainly agree that no article can cover everything. And you covered much more ground (and heeded constraints better) than I did: I needed more words (ca. 2,750) to make 2-3 points than you did (ca. 1,800) to make nine! And certainly the debate about valuation is complicated. But if one adjusts PEs for low rates of interest, as you "tend to favour" in your comment (I don’t disagree), why adjust them upwards? Why not downwards – to reflect the cul-de-sac (to put it mildly) into which hyper-interventionist central banks and governments have driven us? On 14 Sept 2008, Glenn Stevens informed the House of Reps Economics Committee that the RBA would adjust its Overnight Cash Rate from its “exceptionally” low level (a 49-year low of 3%) “when the time is right.” Stevens elaborated: “there will come a time when the exceptional monetary stimulus in place at present will no longer be needed … It will then be appropriate for the board to do what it has done on past such occasions, namely to start adjusting interest rates back towards normal levels.” More than 12 years later, according to central planners/bankers, that time clearly hasn’t come. Indeed, today’s target OCR is 0.25% – and the RBA’s cheer squad reckons that it’ll shortly fall further. If a 3% OCR was “exceptional,” then what’s 0.25% or less? At what point will market participants (never mind the RBA!) recognise that, just as central planning in general inevitably fails, so too do its variants – such as monetary central planning? If and when they do, surely that implies a much lower, not a high or higher, multiple? Chris

Wade Spooner

Hi Chris, I really enjoy reading your articles. I agree that the P/E's you've highlighted are extreme, even scary. But, I have been watching the P/E10 for Australia which suggests valuations are more reasonable as it is at 19.5. Could you add any comments about Australia's CAPE?

Chris Leithner

Hi Wade The cyclically adjusted price-to-earnings ratio (commonly known as CAPE, Shiller PE, or PE10) is defined as price (say, the All Ords at month’s end) divided by monthly measures of earnings (moving average over ten years, adjusted for CPI). It’s primarily used to estimate future returns over 10 or more years: higher than average CAPEs implying lower than average long-term returns, and vice versa. Using CPI-adjusted earnings over the last decade helps to smooth out the impact of business cycles and other events. Oversimplifying for the sake of brevity, CAPE “works” when earning are cyclical – but seemingly emits false signals when they’re not. Monthly measures of the All Ords’ earnings since August 2010 (nominal and CPI-adjusted) were nicely cyclical; over the past couple of months, however, they’ve cratered. Their mean over the past decade is $340 – versus $157 in August 2020. Accordingly, the CAPE for August 2020 is far lower and closer to its historical average than the normal PE. If earnings remain depressed compared to pre-covid – if like the GFC, the GVC has caused a structural rather than cyclical change – then subsequent CAPEs (whose “E” will comprise mostly and unrealistically high earnings) will emit an increasingly false signal. That is, CAPE will be biased (too low) compared to the normal PE and will over-estimate future returns. Chris

Peter riddell

Great analysis. Independent thinking. I would be very interested in seeing a similar analysis of the other great retail investment : residential property

Peter Just

Very interesting articles. However most investors cannot reinvest all of their dividends due to taxation. Any analysis of this would be complex, but it is worth noting.