The Australian and US share markets reached all-time highs at the end of last week. This is great news for superannuation returns and existing share investors. However, where will the markets go from here?
When valuations are high, future returns will be low
There is a
strong negative correlation between the starting valuation multiple (e.g. price-earnings ratio) and an investor’s subsequent 10-year investment returns. That is, if current valuations are high, future returns are likely to be low. This makes sense because if you invest in a company or market that is currently fully valued, there isn’t a lot of upside left. In fact, it could be that you are overpaying to invest in that company or market. If that is the case, you could experience capital deprecation.
The US market valuations appear elevated
The
CAPE ratio is a widely accepted measure of a market’s current valuation relative to history. Currently, the US market’s CAPE ratio is over 30. The long-term average is in the range of 18 to 22, depending on the period and adjustments made. The US CAPE ratio has only been above 30 two times since 1871:
- in 1929 when the share market crashed nearly 25% (Black Tuesday) – the CAPR ratio was 32.5; and
- in December 2000 when it reached 44 during the dot-com boom. The NASDAQ-100 lost 78% of its value between 2000 and 2002 (called the Dot-Com Bubble).
Am I saying that the US market will crash? No. In fact, the CAPE ratio is not a reliable indicator of short-term market movements, only long-term (10 year) returns. But this analysis does indicate that US market valuations are alleviated and as such, history tells us that future returns will likely be lower.
What about Australia and rest of the world?
Australia’s CAPE ratio is currently 18.4 which is above its median at 16.5. Fair value is considered to be 17.1. So, whilst the Australian market appears to be slightly overvalued, the differential isn’t as much as the US and other markets. It is important to note that most developed
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