Australian (ASX 200) stock market including the cyclically adjusted price earnings ratio (PE10 or CAPE) – May 2010 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted PE ratio (known as the PE10 or CAPE) for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller for the S&P 500. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 = 26 and will own 30% more stocks when the ASX 200 PE10 = 6.

Chart 1 plots the ASX 200 PE10. Key points this month are:

ASX 200 PE10 = 16.49 which is down from 18.55 last month. My target Australian Equities target is now 20.7% which is up from 19.0% last month.

ASX 200 PE10 Average = 22.8. This would imply the market today is 28% undervalued using this measure. I am concerned about this as my dataset is quite young dating only from 1993 and so may not have enough history built into it.

If I look at the S&P 500 data set since 1993 its PE10 average has been 22.5 which is very similar to the ASX 200 PE10 average, yet since 1881 has been a much reduced 16.4. If we assumed that the ASX 200 also dated back to 1881 could its average also have been around 16.4 implying that today the ASX200 with its PE10 of 16.49 is about fairly valued?

ASX 200 PE10 20 Percentile = 17.3 down from 17.4 last month

ASX 200 PE10 80 Percentile = 27.6 which is down from 27.7 last month

ASX 200 PE10 Correlation with Real ASX 200 Price = 0.80

Chart 2 plots further reinforces why I am using this method. While the R^2 is low at 0.1566 there appears to be a trend suggesting that the return in the following year is dependent on the ASX 200 PE10 value. Using the trend line with a PE10 of 16.49 results in a 1 year expected earnings projection of 15.7%. The correlation of the data in chart 2 is -0.40.

Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends and Earnings both remain below the trend line but have now both started rising again since the lows in February 2010. Earnings also continue to depart from Dividends which means companies continue to retain profits for investment in future business growth.

As always do your own research.

Assumptions include:
- All historic figures are taken from official data from the Reserve Bank of Australia.
- May 2010 price is the 21 April 2010 market close of 4305.444.
- May 2010 Earnings and Dividends are assumed to be the same as the April numbers.
- Inflation data from April and May 2010 are estimated.