Thursday, February 16, 2012

Without PE Re-rating There's Not Much Appreciation

The period from September 1974 to March 1992 was an incredible time to be a holder of the All Ordinaries.

This was the period after the first oil shock and during which stag/inflation was defeated.

The period was marked by the re-rating of PE ratios from 5.4 to 20.1. That PE re-rating drove huge increases in the value of the All Ordinaries.

When you compare that period to some others of equal length and to the period since June 2001 to now, you quickly see that when you strip out the period of the re-rating of PE's, capital appreciation from the All Ords is very poor compared to commonly quoted numbers like 7% pa.. The capital appreciation shown does not include dividends, which would add a few percent onto the return (and really should not be ignored, but are for the purposes of this comparison).

The table below shows the rates of return after indexing each period to 100 at the start date of that period.

Start Date Sep-1974 Sep-1994 Sep-1961 Jun-2001
End Date Mar-1992 Mar-2012 Jun-1979 Mar-2012
Start 100 100 100 100
End 815 210 197 124
N Per 70 70 70 43
Rate / period 3.04% 1.05% 0.95% 0.51%
Nom Rate PA 12.2% 4.2% 3.9% 2.0%

We can see the same thing graphically which brings the point home more sharply. The sustained dramatic capital appreciation occurred only during the period of re-rating of PE's as inflation was defeated.

We can also see the 2004 - 2007 boom quite clearly in the chart below ( at period 41 to 55 in red and 12 to 26 in yellow) and ask ourselves why we thought it would never end, particulalry when we look at consistency of 10 year government interest rates over the period and the lack of any real boom in GDP growth.

The only consolation we can take is that over the coming 27 periods we could see a higher rate of capital appreciation of 7.1% to the end of 2018 if we are to get to the 200 indexed value seen for the other two 70 quarter periods (not including the re-rating period) in the chart below.

The questions then are,
1. "What sort of appreciation ought we expect from buy and hold in the absence or a significant re-rating of PEs?"
2. "Are we likely to see a re-rating of PEs and if so which way?"

Long term bond yields are presently low compared to earnings yields on the All Ords. If interest rates go down and stay down then a re-rating is possible and even likely over a few years. If interest rates come back up, then there could be big losers in bonds and possibly in stocks.

Overarching all of this is "How long will the Balance Sheet Recession last?"

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