Australia 2007: Boom or Bust?

by wise-owl.com

Monday 22nd January 2007

It has been an emotional rollercoaster ride on the Australian share market over 2006 as traders jumped onto the commodity super cycle earlier in the year, only to watch resources stocks face heavy falls in May. Now that commodity prices are showing signs of a comeback, investors are wondering if the market can really keep on rising after four years of solid gains.

Looking forward, 2007 is shaping up to be another year of respectable gains, although these gains are likely to be less spectacular than those we’ve seen over recent years. Some commentators have suggested we are in a private equity fuelled boom that could easily turn into a bust. There are also fears commodity prices could suddenly fall and leave investors in resources stocks stranded.

While these ideas can make a great story or headline and do have some substance, they ignore the greater weight of data we have on hand. The core fundamental factors that have been driving our market higher lately remain for the most part intact.

The global economy looks strong
Resource hungry China is still growing at more than 10% pa and India’s demand for commodities is clearly on the rise. These nations are both supporting large and growing middle classes, a resource intensive process that is showing no signs of a slow down.

In addition to this we are also seeing a recovery take hold in the Euro region, and Japan seems to be finally putting its deflationary woes behind it. This is not only good for the resources sector but for any company that may sell products to these regions or benefits from the extra activity it stimulates locally.

The biggest concern we face is the US economy, as the housing market in the US has taken a larger fall than many had been anticipating. While the broader impact of this fall is yet to be seen, we can take comfort from our recent experience in Australia and that of the UK. Despite housing slowdowns, both of these markets continued to enjoy very respectable share market returns and economic growth.

But do valuations stack up?
However, after almost four years of strong market gains, do valuations still stack up? Obviously, if you’re going to invest in a market like ours that is pushing record highs, you really want to be sure that earnings are also at record highs. This is because company earnings are quite simply the key driver of any stock market over the long run.

If earnings were not keeping up with gains in the market, before too long you’ll have a bubble on your hands. While bubbles can be profitable for a lucky few, the majority of investors have a tendency to lose out when these bubbles turn pear shaped. Fortunately earnings are at record highs and as such justify high stock prices.

Earnings are at record highs and growing. That’s great news for our share market.

Price to earnings multiples (PE) are also a great way to gauge a markets valuation. In Australia the average PE ratio has tended to hover around the 15 mark, and as you can see below, has frequently been much higher than this. Right now the average PE ratio is actually closer to 14.3. This means that even though our share market finds itself at record high levels, it still represents good value. In fact the PE ratio of the market today is very close to what it was at the bottom of the bear market in early 2003! No wonder private equity firms are happy to buy up our listed companies. Quite simply, our market is nowhere near bubble territory.

Looking at historical data, PE ratios for both the Australian and US share markets show that shares still represent good value overall.

Time to get that bubbly on ice?
All things considered, the prospects for Australian shares continue to look good. Barring any ‘X-Factor’ events there is every chance the market will post yet more record gains in 2007. Importantly, earnings outlooks continue to look favourable and if anything, when you look at the cold hard facts our market is actually trading below what would normally be considered fair value. As uncomfortable as it is buying into a market at record highs, valuations still stack up and prospects for many stocks are looking good.

Wise-owl.com is one of Australia's leading independent research houses. We empower all levels of investors and traders with education, advice, actionable strategies and risk management techniques. Our investment philosophy is based on a combination of quantitative, fundamental and technical analysis that has been proven over the years to produce very consistent and powerful returns.

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