Trailing JSE Price/Earnings ratio down for January

Ian de Lange of Seed Investments writes that the December inflation data was released on Wednesday last week, reflecting a year on year price gain of 6,3% up from 5,8% in November. This rise above the upper range of the current target of 6% is seen as a temporary blip.

 On Tuesday the Monetary policy left interest rates at 7%, which kept banks to hold their prime rates at 10,5%. There is a possibility that rates may still drop by a further 0,5% in the next few months.

The extent of the 2009 rebound in valuations is seen on the chart below, which graphs the trailing price to earnings ratio of all the shares listed on the market.

The long run average price paid per R1 of earnings is R11,50. The average since 1990 for R1 of company earnings is R14,38 and at current prices after the strong rebound in 2009, the average price being paid is close to R17 for that R1 of earnings. 

The most recent bull market in equities from early 2003 to early 2008 saw a starting point where weak company earnings were rated at low multiples. As company earnings started to improve in 2004, 2005 and 2006 at percentages above their longer term trend, so investors became increasingly willing to pay up for equity ownership.

The result was a strong expansion in company earnings and an expansion in the prices that investors were prepared to pay for these earnings, resulting in a strong bull market for equities.

The question now is have markets been shaken down substantially in the 2008 collapse so that the 2009 rebound is just the start of another multi year bull market?

On a secular outlook it all comes back to earnings. We know that year on year company earnings on the JSE fell 23% to December, while share prices rose 32%.

Because prices tend to move ahead of the actual earnings, there is a high possibility in 2010 that even as company earnings start to “normalise” again from their current levels, that this does not immediately translate into further price gains.

It does appear that the current valuations on the market are looking for strong earnings growth to support the more expensive prices. Surveys are indicating that many institutional money managers are reducing exposure to local equities after the strong rally.

The shorter term outlook for local prices however is less dependent on earnings and valuations and more keenly driven by cash flows. We know that the accommodative monetary policy in developed markets has resulted in foreign inflows into SA bonds and equities driving up prices. How long this persists at current inflows is impossible to predict.

We are now at the end of the first month of 2010.  The local JSE is down around 3,6% for the first month of 2010. This has brought down the trailing price to earnings from 17,6 times to the current 16,5 times.