Why ASX Stocks Might Be Overvalued

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Only seven years ago, the S&P/ASX 200 was trading at lows not seen since 2004. Over the course of a two year period (late 2007-early 2009), the market dropped more than half. From its peak of 6754 points, the market tumbled to 3344 in a relatively short time.

SP ASX 200 Trading

Source: Investing.com

Before the drop, the ASX was overvalued. This also coupled with the global meltdown that originated out of the US at the time. However, after what seemed like the end of the financial world, the ASX recovered remarkably quickly. Just six years later, it was again nearing the 6000-point level.

ASX Share Price Crisis

Source: Investing.com

But did it recover a bit too quickly? During the crisis, it didn’t seem to end. However, the effect for some of us didn’t last long enough, and I say that with the greatest respect to those people who lost their homes. However, some had it even worse, losing their entire retirement funds.

And these people are still living in the aftermath of what took place seven years ago. They’ve had to take on a second job. Many have been driven out of retirement just to survive. People were left bloodied along the way…but the market seems to have shrugged things off without a care.

Now, in 2016, the doomsday voices are getting louder. A market catastrophe is heading our way, according to some. An article in the Australian Financial Review this morning highlighted Deutsche Bank’s view on the Aussie market. The article opened as follows:

Global uncertainty is clouding the Australian share market’s ability to hang on to its high valuation, but the domestic economy is on track and investors should take bouts of weakness as buying opportunities in selected value stocks.

The ASX 200 is trading at a forward price-to-earnings (P/E) ratio of 16 times. P/E ratio is just the market price of a share divided by earnings per share (EPS).

Where does the forward come in? Using the expected value of EPS, rather than the current value, creates this forward-looking metric. And according to Deutsche Bank, the ASX 200 has been trading at this elevated level for the past two years. The bank now states that this is ‘fair value’, or in laymen’s terms, the new normal.

Market PE ratio 12m forward earnings

Source: IBES, Deutsche Bank

But instead of taking Deutsche Bank’s comments at face value, let’s look at what value investors have to say — in particular from esteemed investors like Warren Buffett.

Before we do, why do we want to see what value investors are doing?

Value investors are concerned with buying undervalued stocks for the long term. It means that, if value investors are more active in the market, it’s a good sign that stocks are undervalued. Even the whole market could be undervalued under this scenario. Yet if the opposite is true, then many stocks, or even the whole market, could be overvalued.

Now let’s see what Buffett thinks of the Australian market. Back in 1999, Buffett predicted that the share market would drop simply by using the eponymous ‘Buffett Ratio’.

The share market did in fact drop. It was the eve of the tech boom, and markets became overinflated.

OK, so what’s this ratio?

The Buffett Ratio measures the total market value of all publicly-traded companies as a percentage of a country’s business sector. So in order to calculate this ratio, all we need is the market cap of all Aussie stocks, plus Australia’s gross domestic product (GDP) figures.

To keep things simple, think of it as a price-to-sales ratio for the whole of Australia. The average for the Buffett Ratio is typically around 100%.

To demonstrate its assumptions, if we look at the market in 2007, the Australian Buffett Ratio reached a peak of 151%.

Keep this in mind; the market capitalisation of the ASX is $1.62 trillion. This includes all indices within Australia. Meanwhile, the latest Australian GDP figures are around $1.59 trillion.

Therefore, the current Buffett Ratio for Australia is around 101.88%.

So while it might be arguable that the Aussie market is overvalued, it’s probably not overvalued by much. Instead of listening to the ‘noise’ in the market, listen to value investors.

Härje Ronngard,

Junior Analyst, Money Morning

PS: If you want to lay down a little money on the hottest corner of the ASX right nowbut you dont know your way around the small-cap sectorthis report is for you. Get access now (free).

About Money Morning Editorial

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the…

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