Is the market overvalued or what?

16:00, Feb 02 2013
Bubble warning: Sam Stubbs of Tower Investments.

So, is the the market overvalued or what?

Ten days ago we had headlines about bubbles forming, based on remarks from Tower Investments CEO Sam Stubbs.

Several other professional investors then said they thought Stubbs' view was overstated, not least Brian Gaynor of Milford Asset Management, who said it was "quite frightening to hear a leading investment industry executive arguing this week that the NZX was heading into bubble territory when it has had so little growth over the past 25 years".

Gaynor's view was followed up by a blog from Milford portfolio manager Mark Warminger saying the market was "a long way from frothy".

Small investors may find such tit for tat unhelpful. After all, most of us would prefer clear statements about where the market's going, wouldn't we?

The trigger for all this reflection on market value has been the persistent rise in the main index measuring local share prices, the NZX50, which is approaching levels last seen in mid-2007, just before the collapse in the global financial crisis.


Back then, the index hit 4320. This month it topped 4200, having gained about 27 per cent over the last year.

At these heights investors may start to feel giddy.

However, the first thing to note here is that a market naturally features different views of value - for every buyer there has to be a seller - and professional investors don't make a name for themselves by agreeing with everyone else.

For Tower and Milford to see things differently is only to be expected.

What's more, their views may be linked to their commercial stance. Tower is a big institutional investor with a naturally conservative bent owing to its status as an insurer and default KiwiSaver provider. Milford is a boutique fund manager focused on active equity investment whose main KiwiSaver product was initially called the Milford Aggressive Fund.

Tower tends to avoid companies that don't pay a dividend, while Milford is comfortable taking stakes in non-dividend paying growth companies such as Diligent.

Perhaps it should be no surprise to find Tower making comments that might appeal to risk-averse investors.

Still, fund managers do agree on some things about the New Zealand market.

Warminger noted "the one year forward price/earnings multiple of the NZ market is currently around 15.5 times compared to its long-run average over the last 10 years of 14.7 times".

These are the numbers potentially indicating an overvaluation.

The price/earnings ratio is simply the price per share divided by the profit per share, but in this case Warminger was quoting a ratio based on forecast profit rather than the most recent annual result.

So if shares are $1, say, and forecast earnings are 6.67c, the forward p/e is 15, but if forecast earnings were 7.14c the forward p/e would be 14 - the lower the forecast profits, the higher the forward p/e ratio and the more expensive shares look at current prices.

Warminger argued the relatively slow recovery has made analysts over-cautious "and we believe that earnings are likely to exceed expectations over the next year as the economic recovery continues and gains pace".

Hence shares are not as expensive as they seem.

Another fund manager, Matt Goodson of BT Funds, has also been looking at forward p/e ratios.

"What we've done for a long period of time is looked at a very consistent series of one-year forward p/e ratios. That's using, from the same forecaster for the main companies, what the p/e ratio looks like one year forward."

On Goodson's numbers the one-year forward p/e is currently about 15.5 compared to the long-term average of about 14.6 times, while the 10-year bond yield at December was 3.56 per cent compared to the average of about 5.6 per cent.

"The p/e right now looks slightly more expensive than normal, however bond yields are well below normal, so therefore the market is still a little bit cheaper than average."

Having said that, some companies were looking inflated, he said.

"At the smaller end of the market there are companies with - what's a polite way to say it? - unproven business models . . . Because money's so cheap people appear willing to put very large multiples on smaller cap growth companies."

There's probably no argument about that from the likes of Tower.

Anyway, the general thrust here is that perhaps it's not time to call a market peak just yet, but we should probably be as wary as a wildebeest with lions on the prowl.

"To me the much more interesting question at the moment isn't whether the market's cheap or expensive . . . it's what happens if bonds sell off," said Goodson.

In bond markets, falling prices mean rising interest yields.

After similar conditions in the early 1990s, a sudden increase in interest rates led to a big drop in the sharemarket, "and small caps were utterly decimated".

It doesn't follow that the same thing will happen again - a small rise in rates could be a positive sign of more normal conditions returning - but as the bubble word is being used about the sharemarket here, elsewhere it is being attached to bonds.

Last week Financial Times commentator John Plender wrote: "The ominous upward creep in US Treasury bond yields in recent days leads to the inevitable question. Could this be the beginning of the end of the great bond market bubble?"

Of course, no-one knows. But at the very least, we probably shouldn't expect a sharemarket tailwind in 2013 like we had in 2012.

Sunday Star Times