Is the ASX’s lost decade about to end?

Spotlight 10 November 2017

For shares to hit peak, company earnings must improve. And that looks likely, writes Mark Rider.

The Australian sharemarket has just hit the 6000 mark, but remains well below its peak, which it should have returned to by now.

It’s been 10 years since the S&P/ASX 300 rose above 6800, and it’s time it got back to that. This is the longest period, for the good part of a century, that the sharemarket has delayed returning to its previous all-time high levels.

Even following the Great Depression and the 1987 sharemarket crash, the market revisited its peak at least sometime within the 10 years following those events. We’re behind schedule.

To be fair, we did suffer the devastating blow of the global financial crisis almost immediately after the market peak in 2007. Since then it’s been a slow but fairly steady pace to regain value.

We can see in the below graph of the S&P/ASX 300 index performance (which incorporates the biggest 200 listed companies and 100 smaller ones), that there’s still a sizeable step for it to hit the peak level (6845) it reached back in October 2007.

S&P/ASX 300 index performance 2007-2017


Why have Australian shares underperformed?

The key reason is that Australian companies are not earning enough to push share values higher – there is a very close relationship between companies’ earnings and sharemarket performance.

And the major reason for this is that the commodity boom is well and truly over. Australia’s resources companies are only earning half what they were 10 years ago, reflecting the collapse in commodity prices. For example, iron ore has suffered a 67 per cent fall in the past decade, closely followed by coking coal which has fallen 43 per cent.

But even outside the weaker resources sector, earnings for the wider market are below the 2007 peak by around 10 per cent.

Sharemarket performance v earnings performance

Sources: Thomson Reuters Datastream, ANZ Wealth

We can see the relationship between company earnings and sharemarket performance very easily taking a quick look back.

  • Before the China boom, that is 1993 to 2003, trend earnings growth was 3 per cent.
  • In the commodity boom earnings exploded, doubling in four years (2004 to 2007).
  • During the global financial crisis earnings fell under a weaker economy.

If we had remained on the 1993-2003 trend (and there was no boom or crisis), earnings would have risen sufficiently to put the market beyond the 2007 peak by now. But the global economy and markets changed significantly in the wake of the financial crisis, leading to where we are now.

The crisis put a stop to China’s unrelenting rapid growth in demand for our resources, the surging growth of developing economies and a loose, easy state of financial affairs fostered by lax regulations.

Looking carefully at the sharemarket and company performance we can see that now:

  1. the pace of growth has slowed, partly because Australian companies pay out profits rather than reinvest them in their business
  2. return on equity (a measure of profitability) has collapsed well below its peak in 2007 and hasn’t come anywhere near reclaiming that level.

But what these trends do indicate is that shares are now fairly valued (compared to when the market peaks and they’re typically 50 per cent overvalued). The conclusion is that the market is within striking distance of its 2007 peak but a few things still need to go right to make it happen.

What will it take for the sharemarket to hit peak?

The way it can get there, as it has previously, is for company earnings to rise above the current trend, and for a rise in the price-earnings ratio.

With the price-earnings ratio for listed Australian companies now above trend, stronger earnings are the more likely catalyst to jolt values. A stronger economy, which would eventually lead to stronger earnings per share, is needed.

Australia’s underperformance in recent years may now well be followed by a period of better returns. But whether we scale to previous heights will, as always, be dictated in large part by the global investment cycle. At this stage it’s giving a glimmer of hope as economic  growth remains strong without the usual concerns about inflation.