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How High can the Share Market go?

Its a strange world on the money markets

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Share Market Outlook - Dec 1998

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Last Modified 1/12/98

Has this been the shortest bear market in history? In just a matter of weeks the US and Australian share markets have gone from being extremely bullish to bearish and back again. Investors are confused. So are the authorities.

Australia's Reserve Bank in its November half yearly report card says that managing the Australian economy over the coming year will prove to be a substantial challenge. ìWith developments in the world economy again likely to be influenced by sharp changes or reversals in financial markets, the outlook can change over quite short periods,' it said. That's an understatement.

A bear market is said to exist when share prices fall 20 per cent from their peak. When the Russian crisis occurred US share prices did just this. A bull market is said to occur when prices rise by 20 per cent. When Alan Greenspan, head of the US Federal Reserve, reacted to the rapidly growing economic gloom by announcing two cuts in interest rates, prices rebounded. So are we back to where we started?

Small investors in the United States at least are convinced that the good times will continue to roll. Since 1982, a 16 year period, share market returns in the United States have averaged an incredible 17.7 per cent a year and 15.6 per cent in Australia. It has been one of the longest bull markets (with the occasional bump or two) in history.

In the US the Standard and Poors 500 Index now has an average price/earnings ratio of close to 28 - one of the highest levels it has ever reached. (The P/e ratio is the current share price divided by the earnings per share. It can be seen as indicating the number of years it would take for the share price to be repaid by the company's profits.)

As a rough rule of thumb a price earnings ratio of around 11 or 12 is considered cheap. A P/e of 15 or so is considered to be about fully priced. P/es above this are considered to indicate shares are expensive.

In Australia prices are not quite as high. The P/e average for our market is just a shade under 18 which is cheaper than the US but still bordering on being expensive. P/es higher than this can be justified if for example there are expectations of strong profit growth and strong economic growth. But most economists are forecasting a sharp slow down in growth over the next 18 months - both in the United States and the rest of the world.

They could be wrong of course but the current betting amongst most analysts is that they are probably right. Yet small investors in the US market, the ones who are really driving stock prices higher, remain extremely bullish. A recent poll indicated that over the next decade these small investors expect to receive returns of 15.9 per cent annually from the share market.

As Mr Jack Bogle, a veteran US fund manager, pointed out in early November at a superannuation conference in Adelaide, to achieve this company profits will have to grow extremely quickly or there will have to be an ever bigger expansion of the P/e ratios. Over the longer term profit growth by US corporations has averaged around six per cent a year. even if they can achieve eight per cent over the next decade, the P/e multiple would have to expand to a staggering and unbelievable 72 to generate shareholder returns of 15.9 per cent.

Even returns of half this are wildly optimistic. The crucial point in all this will be the reaction of small shareholders when they inevitably become disappointed. At present the savings rate in America is close to zero with many consumers spending all their income and some of the capital gains as well. If the capital gains dry up, there could be a reaction that will see US spending wind down.

Depending on the severity of this effect, a contraction of the US economy is a distinct possibility. This would inevitably have rather alarming effects on the share market. Hopefully this will not occur and Alan Greenspan will manage to tame things rather than destroy them. But with world markets so volatile, the risks remain high. The latest charge of the bulls could be simply their last final fling before they back off and make way for the bears.

David Tomlinson
Finance journalist