Smart Investor Acid Test: should you buy Australian shares?

Smart Investor: Acid Test, January 2011

Is now a good time to buy Australian shares?

1. Do you think the latest rally has further to run?

At the time of writing the S&P/ASX200 was up 10% in just four months – ready for a reversal? Well, share market performance all depends on where you start looking from. It’s true that there has been a recent recovery, but we are still well below where we were in April and early May, and an absolute mile below where we were in 2007 – the market would have to put on almost 50% to reach that level again. If you believe that markets always eventually take out their highs, then the long term trend ought to be upwards.

2. Do you think markets always take out their highs given long enough to do so?

Usually this is true – during the financial crisis it was most instructive to look at, say, a 100-year chart of the Dow and see how insignificant the most crushing corrections can be when viewed over the truly long term. But, that said, there are markets that haven’t been anywhere near their highs in a long time: Japan’s Nikkei 225 hit its all time high in 1989 and is still at barely a quarter of that level even today.

3. Do you set much store by P/E ratios?

A P/E is a price/earnings ratio, and it is a favoured barometer investors use to decide if a stock, sector or entire market is overvalued or cheap. People can get too preoccupied with them but they are a very useful tool as a starting point in deciding on value. Right now, they tell us promising things: at the time of writing the forward consensus PE (that is, based on the average of what brokers think earnings will be next year) is 12.5 times, whereas the long term average is 14.6 times. So, historically speaking, shares are cheap.

4. Are you a believer in yield stocks?

Australia is one of the best major stock markets in the world for yield investing – that is, buying for the dividends as much as capital growth. The overall grossed up dividend yield from the Australian market is 5.3%; Shane Oliver at AMP Capital Investors points out that this is about the same as the 10 year bond yield, meaning that shares only require modest capital growth to provide a much better return than bonds. Some very big name stocks provide a stable and steady yield, such as Telstra, QBE and NAB; some stocks pay higher still, although it’s always worth being wary of something that seems too good to be true.

5. Are you confident about China?

It’s probably asking a lot of the Australian mum and dad investor to have a firm view on China’s economy, but it’s actually very important for Australia. Chinese demand supports Australian resource stocks, and Australian resource stocks support much else of the Aussie economy. At the moment the debate in China is about monetary policy tightening, and revaluation of the currency; few economists expect any momentous change in the short term and in the meantime the economy is soaring.

6. And what about the rest of the world?

Naturally, this is important too: the global recovery needs to have legs in order for Australian stocks to thrive. The jury is still out on a host of things: the US and quantitative easing; European sovereign debt, back in the headlines with the loan to Ireland; worries of asset bubbles in Asia. It’s still choppy, all right.

7. Do you think Australian stocks are cheap compared to the rest of the world?

If you do, it’s not a guarantee of great performance, of course, but it helps. In truth, at the time of writing, Australian and world markets were on roughly the same forward p/e (although the world’s historic average p/e is slightly higher than Australia’s).

8. Do you expect a lot of corporate activity like mergers, buybacks and dividend payouts?

If you do, that’s usually good for shares, though it helps if you’re in the right ones (for example, when a takeover bid is announced, usually the bidder’s share price goes down and the target’s share price goes up). Generally, it’s fair to say that companies in Australia are increasingly cashed up and will have to do something with that money, and if it’s not going on capital expenditure it may go on acquisitions, share buybacks, or payouts.

9. Do you think the world banking industry is in good shape?

There are some who fear it is not, from mortgage foreclosures in the US to overextension to questionable state projects in China. There’s nothing much wrong with Australia’s major banks, but there didn’t need to be anything wrong for the entire market to crash during the global financial crisis.

10. Do you believe the Australian dollar is going to stay high or keep rising?

We ask this because if you do, you’re more likely to focus on domestic investments rather than foreign ones, where any investment gains would be wiped out by further climbs in the currency. However if you think the Aussie dollar is too high and must fall, that’s an argument for putting your money overseas, not at home.

Mostly yes: Go ahead and buy Australian. Just because you’ve missed the start of the rally doesn’t mean you need to stay out.

Some yes, some no: It’s always worth having some exposure to Australian shares but keep your options open, both in terms of other investments, and cash on hand.

Mostly no: Steer clear. Things will get worse before they get better.