Share ownership has sharply declined in Australia since 2007, despite the market showing some strength. In 2007, shares were about 40% of all super fund assets, now they are only about a quarter. More surprisingly, there has also been a decline since 2011, when shares were about a third of super assets. This probably reflects the rise of SMSF super. SMSF investors are more averse to shares than professional intermediaries. Outside super funds there has also been a decline in interest. In 2007, shares were about 10% of all household assets, now they are below 6%. It is a big drop.
Should shares be increased in portfolios? There are many ways for SMSF investors to assess the value of shares (equities). One way is to compare them with bonds. This is done by taking shares' earnings multiple (price earnings ratio, or PE, which is the share price divided by the earnings per share) and comparing them with interest rates. Deutsche Bank has looked at this and concluded that Australian shares are relatively cheap compared with bonds, but not with other stock markets.
The problem with this analysis is that fixed interest markets, due to the GFC, are extremely distorted -- more so than any time since the Great Depression of the 1930s or the Second World War. Still, it is worth seeing how Deutsche goes about doing its comparisons:
"Australia looks expensive vs other markets, but should stay supported. While the Australian PE ratio is quite high vs global markets (both in absolute terms and relative to history), we see it remaining supported for two reasons. (1) The cyclical parts of the market have arguably been under-earning (reflected in their share of market cap around a decade low of 37%, vs the average of 44%), and investors might look forward to normalization. (2) Fund flows are likely to stay supportive. Both super funds & households are underweight equities, and super funds are receiving robust inflows ($120bn annually, 50% of which is discretionary) which need a home.
Traditional PE ratios are quite high, but alternate measures are a little cheap The PE on 1-year forward and trailing earnings is above long-run averages (by 7% & 18%, respectively). But the ‘cyclically-adjusted’ PE (using 10-year trailing earnings) is 5% below the 50-year average. The other PE we consider uses the next year of earnings that are actually delivered, and has averaged 15.3x. If forecast earnings are broadly achievable, (which is our view, given improved EPS revision momentum) the current 12m forward PE of 14½x is a touch cheap."
Deutsche's key message from looking at four types of price earnings ratios is that the market is 4% more expensive than it should be. That is assessing it in terms of historical averages or international equities. But when you look at fixed interest, shares start to look good value:
"Equities look good value vs bonds even if bond yield track higher As is well known, equity yields are cheap vs bond yields. However the gap is less pronounced when we use real, rather than nominal, bond yields, which has a stronger theoretical backing. All up, equities look ~18% cheap vs bond yields, and 4% expensive on PE ratios. Taking the average suggests the market should be 7% higher, which corresponds to our target valuation of ~15½x on 12m forward earnings. Applying that multiple to future earnings that we expect to be a little below forecasts gives us our ASX200 targets."
Deutsche likes cycical stocks rather than defensive stocks, which it thinks are undervalued. A big reason for thatdefensives are liked by DIY super investors, who prefer low risk corporates, with their high dividend yields. But Deutsche is advising to look a little further:
"Australian cyclicals are less expensive, and the fund flow backdrop looks supportive Even so, we see scope for the market to remain supported relative to offshore, for two key reasons. Firstly, cyclical stocks are arguably under-earning, as suggested by their low share of market cap. Resources & cyclical industrials together account for 37% of the market, compared to the 10-year average of 44%. A normalization of earnings in time should lift this ratio, and investors may be willing to look ahead and pay a higher near-term multiple than normal."
The belief that funds will flow into cyclical stocks is questionable given how low risk SMSF investors tend to be. But it is worth a look.