Cheap valuations

November 25, 2011, 10:37 am Julia Lee Yahoo!7

While some commentators are saying valuations are cheap for the market, you need to consider that valuations can get cheaper.

How often have you heard over the last few months and even years that valuations on the Australian sharemarket are cheap? The market is still 40% below levels seen in 2007. Throughout 2011, assertions that the Australian sharemarket is undervalued have been repeated time and time again.

It's true. Valuations on the Australian market are looking cheap compared with the average over the last couple of decades. However, just because something is cheap doesn't necessarily mean that it is a profitable investment.

What is cheap often gets cheaper

For investors looking for bargains, how do you gauge if the time is ripe to buy stocks? In this article, we'll look at identifying turning points to help you determine whether stocks will get cheaper. (More from Julia Lee: Understanding Volatility)

What is 'cheap'?

Value on the market is often measured through the Price to Earnings ratio (PER). Over the last two decades, the average PER of the Australian market has been 16.3. With the current PER of the Australian sharemarket at 12, you can see that the Australian market is looking cheap compared with the average over two decades.

image

If you use PER as a way value the sharemarket, then of course the Australian market looks cheap in 2011. But think about this…if you thought the market was cheap in April 2011 a PER of 14.6, you'd be right. But then it was even cheaper in June with a PER 13.9. Get my drift?

The point is that if you had bought in April when the market was cheap at 14.6%, you would be annoyed with yourself because the market was even cheaper in the months afterwards. Even now, stock prices are down 12%.

Should you use average PERs?

If you want short-term performance, for example over one year, then average valuations don't really help you determine the right time to buy. (More from Julia Lee: A New Way To Trade International Shares)

Consider this: the PER for the Australian sharemarket during 1974 bottomed at 5.6. But the average PER for the decade from 1974-1984 was higher at 8.8.

So while the current market average of 16.3 over the last two decades shows that valuations right-now are looking cheap, who's to say that those valuations won't go further south?

Watch the slope

A more effective way to use valuations is to watch for a change in the slope of the PER. Looking for a change in the slope is a more effective way to help you avoid pain while searching for cheap valuations.

In the chart above you can see right towards the end of the slope that there has been an uptick in the PER, which means valuations have risen. If this trend continues, it could be a sign that the tide has turned and valuations may have already found their bottom. (More from Julia Lee: Trading In A Bear Market)

The trick is to look for a bottoming trend in valuation indicators rather than basing your strategies on single numbers, like comparing against average PERs.

Secular bull vs secular bear markets

I've talked before about bull and bear markets, but there's no harm in recapping those concepts to help you consider valuations.

Since the market peaked in 2007, Australian shares have lost 40%. The Australian market is now in a secular bear market and must be treated differently to a secular bull market.

In a secular bull market, prices are generally rising over a long period of time and a buy and hold strategy works well. In a secular bear market, a long-term buy and hold strategy does not work since prices are falling over a long period of time. In a secular bear market, it becomes really important to identify turning points.

Remember Japan's famous secular bear market which saw prices fall 80% from the peak in 1990? Then there was the trough during the global financial crisis. Most buy and hold strategies would not have held up well during that period. Back then, it would have been crucial to identify the turning points. Even within in that secular bear market, there were spectacular cyclical bull markets. The biggest one was 2003-2007 where the market rose a stunning 125%!

So while commentators are busy saying that valuations are cheap for the market, you need to consider that valuations can get cheaper. The most important strategy you can adopt now is to find the turning points in valuations and then act on them.

Happy trading!

Julia Lee
Equities Analyst

Bell Direct

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