Friday, April 30, 2010

Equities: Proceed with Caution

High PE ratio = danger

Historically, the market has only spent 15% of its time at a PE ratio of 16 or higher. The market is currently at an un-nerving PE ratio of 17.6. Historically it has only been higher than this level 6% of its time, therefore the market is not cheap if history is anything to go by.

Historically there have been 6 (broadly speaking) periods where the market has broken through a PE ratio of 16 (see Figure 1). We can test the theory of "high PE ratios equate to poor commensurate equity returns" by tracking the performance of the equity market as the PE ratio goes through some predetermined level. Setting the PE ratio at 16 generates some interesting results with regards to equity market vs. cash returns. The subsequent 3 year returns (post a PE ratio > 16) for the All Share Index (yellow) and Cash (red) are plotted in the graph (Figure 2) below.

Briefly what does the graph above (Figure 2) say?

1. Cash has out-performed equities 4 out of the 5 times over a 3 year period.
2. The market has experienced a serious crash within 3 years, 2 out of 5 times.
3. The market has rallied at least 34%, 5 out of 5 times from the point the market PE ratio goes above 16.

In summary the All Share Index has fared poorly relative to cash over a 3 year period when the PE ratio has breached 16. Secondly it is important to recognize that the market can initially perform very well over the short-term even when the valuations look very expensive on a PE ratio basis. Figure 2 and Table 1 highlight this fact with interim returns having reached between 34% and 68.5% before market returns turn sour.