The one question I’m asked most often is: “Where is the JSE going next?”. The short answer is I have no idea and nor does anyone else. However, we can use history to provide some guidelines. More specifically, we can use long-term valuations of the JSE to give us our best indication of what to expect in the medium term.
Price/Earnings ratios are instructive
The index level of the JSE All Share Index is a largely meaningless number. In essence it shows the direction and speed at which all share prices are changing on a daily basis. Whether the index is at a level of 22 000 or 40 000 is not really meaningful to long-term investors. What is relevant is how quickly the index level changes over a period of time. For example, if the index drops from 40 000 to 30 000 over a period of six months, long-term investors should start getting interested because they might find bargains.
If the JSE All Share Index is trading close to all time highs, should we infer that the whole stock market is expensive? I don’t think so. Instead, I prefer to look at the price/earnings (PE) ratio of the market to determine when the JSE is starting to look pricey.
The PE ratio of the market tells us how many years of future profits will be required to pay for the price of the market today. The long-term average PE ratio of the market is 14, which means it will take 14 years’ future profits to pay for the market at today’s prices. The graph below shows us the PE ratio of the market from 1998 to 31 January 2013. The solid black line is the long-term PE of 14 and the two dotted lines (above and below the solid line), indicate when the PE has moved significantly above or below this average.
It is only when the market value moves above or below these dotted lines that I start to worry about the future direction of the JSE. If the PE rises above the top dotted line, it means the JSE is starting to become expensive. Therefore it is more likely to fall over the medium term than it is to rise. For investors it is a time to be particularly cautious with your money and perhaps consider taking some profits, especially if you are over-invested in shares. At current levels, the All Share Index is near 40 000. But the PE ratio is still below 16, which means it is not expensive.
This does not mean I think the market is cheap, far from it. I believe the market is cheap when the PE drops below 12. At present, some sectors of our market are very expensive and should be treated with caution. Most retailers and international companies are very expensive. New investments into these sectors should be made with great caution. Other sectors of our market are offering good value though. This is why the PE of the whole market is not too high.
Adrian Saville from Cannon Asset Managers points to commodity and domestic industrial firms that have been overlooked by international investors as sectors offering good value. Sectors that are currently in the news for all the wrong reasons, e.g. platinum miners, are offering great value.
We need to remember the PE ratio is an average. Real problems can be hidden by averages. Just like the man who was an average temperature, because he had his head in a fire and his feet in ice. I feel you should treat this market with caution. But there is still value to be found for patient investors.
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