Introduction
Much has been made of the ASX 200 index recently breaking through the 6,000 mark for the first time since the GFC. While important to note that this is just a number, for many investors this milestone does represent an important psychological threshold and anecdotal evidence suggests that investors are becoming increasingly concerned about the prospects for a market correction.
But what, if anything, do current market levels tell us about the risks for investors?
Mid to small caps have led the way
As can be seen from the graphs below, much of the rally in the market over the last six months has been led by smaller companies, with both the Mid-Cap 50 and Small Ordinaries Indexes substantially outperforming the market. In contrast, the ASX 20 Index, which comprises approximately 70% of the ASX 200 total market capitalisation, has underperformed the overall market by 2.5%.
The growth in the mid to small cap sectors has been concentrated in those ‘market darlings’ that are perceived to have the highest growth prospects. Recent analysis by Investors Mutual has identified 13 of these high profile growth stocks that have a combined market capitalisation of $24.4 billion and that now trade on an average forward P/E multiple of 50x. Over the 3 months ending 31 October, the growth in individual stock prices ranged from 30% to 110%.
Source: Investors Mutual. Based on share prices at 31 Oct 2017.
Most large caps have lagged the market
In contrast to the small to medium cap sectors, larger companies with more subdued short-term growth prospects have performed relatively poorly. Of the 20 largest companies listed on the ASX, only 8 are currently trading within 5% of their 52 week highs.
Most of Australia's largest companies, including the four big banks and resource giants BHP and RIO, are trading on forward P/E multiples of 12-14x which is approximately one quarter of the value of the small cap market darlings in relative terms.
Overall market valuation is still reasonable
Although the market P/E ratio is currently above the long-term average, this in itself is not a cause for concern. After all, in order to maintain the average, the market must trade above the average by the same amount (in terms of time and level) as it does below the average. The graph below shows that, relative to previous cycles, the ASX 200 has plenty of scope to trade higher and for an extended period based on the historical market average P/E.
It is also important to note that the market is likely to trade above the long-term average P/E level when companies are in an earnings upgrade cycle. While large domestically focussed companies are facing subdued short-term earnings growth, forward P/Es for the resource companies are still based on commodity price forecasts that are well below spot prices and there is a high likelihood that earnings estimates will be raised over the coming months.
Where to from here?
At JJT Advisory, we are firm believers that one should not attempt to predict short term movements in equity markets. We are of the view, however, that nearly all of our portfolio holdings are trading at prices that are still attractive from a long-term investment perspective. Given our focus on investing in companies with proven business models trading at reasonable valuations, we are not exposed to any of the expensive growth stocks. While this may contribute to short-term underperformance if these stocks continue to run, we think it positions our client portfolios for more sustainable long-term returns.
DISCLAIMER
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.