Shares have risen sharply from their lows in March.
Global and Australian shares are up by around 45%.
This naturally has some concerned that shares are now expensive.
The AMP’s Dr Shane Oliver says there’s good news in the profit reporting season that has just ended.
"Our assessment is, firstly, that shares are still not expensive and, secondly, future gains will be further underpinned by an improvement in the profit outlook”
Reporting season for Australian shares
While Australian 2008-09 profits are down around 18% making it the biggest slump since 1990-91, it has not been the disaster that had been feared.
In fact, the profit reporting season overall has been pretty positive.
Firstly, positive surprises have dominated making it the best season for results relative to expectations in two years. 44% of results have come in better than expected compared to only 18% below.
This is a big improvement on the last two reporting seasons when there were more companies surprising on the downside than the upside.
In fact, the net balance of positive less negative surprises of +26% is the best it has been since the August reporting season two years ago. (See the next chart.)
Secondly, company outlook statements have been far more positive than was the case in the last two reporting seasons.
While companies remain somewhat cautious, positive outlook comments have dominated negative comments by a ratio of nearly four to one, whereas in the last two reporting seasons negative comments dominated.
Other key themes have been strong margins thanks to cost control and the economy holding up better than feared six months ago, dividends being cut but not by as much as expected and continued capital raisings in order to reduce gearing and (possibly) fund takeovers.
By sector, the key areas of upside surprise were in energy, retailing and capital goods and the key areas of downside surprise were in real estate, transportation and telcos.
As a result of better than expected results and more favourable outlook statements, equity analysts’ earnings expectations for the 2009-10 financial year have been upgraded by around 3%, signalling the likely start of an earnings upgrade cycle after two years of downgrades.
The next chart shows that the number of companies seeing their earnings being revised up by analysts for the year ahead now outweighs the number of companies seeing downgrades.
This follows two years of net downwards revisions.
It’s the same picture globally after better than expected earnings reporting seasons in most countries.
With companies having reduced costs and economic recovery pointing to stronger revenues going forward it’s likely that further upwards revisions to earnings expectations lie ahead.
This is favourable for shares.
Are shares now expensive?
There are numerous ways to measure share market valuations.
The simplest way to is to compare the level of share prices to earnings and a common approach along these lines is to use the consensus of equity analysts’ earnings expectations for the year ahead.
This is usually called the forward price to earnings ratio as earnings are for one year forward.
On this basis, global and Australian shares have risen from forward PEs of 8 or 9 times, which was historically low, to now around 15 times which is in line with long term averages. (See the next chart.)
This would suggest that while shares are no longer cheap they are not expensive either.
However, it’s worth noting that year ahead earnings estimates (while being revised up) are still depressed after their recent slump, particularly for sectors like resources and banks.
As a result, the price to earnings ratio is probably being overstated.
One way to adjust for the cyclical volatility in earnings is to use trend earnings.
Taking Australian shares, the chart below shows nominal earnings per share for the Australian All Ords index against its long term trend.
Long term trend growth in Australian company earnings is around 7% pa.
Following the slump in earnings over the last two years, earnings are now below their long term trend.
Taking trend earnings (currently 310 cents per share) as a guide to the central tendency for earnings and applying a PE multiple of 15 times (the long term average) would suggest that fair value for the All Ords index is now around 4650, which compares to the current level of 4500 and suggests that shares are still somewhat cheap.
Another quite useful approach is to compare the level of share prices to the level of profits reported to the tax office and which the Australian Bureau of Statistics reports each quarter.
This measure of profits relates to profits produced in Australia and relates to operating profits and so ignores changes in asset values and offshore sourced earnings.
The chart below shows that over time the Australian share market moves roughly in line with this measure of operating profits.
Right now though shares are well below the level suggested by company profits.
While the share market rightly anticipated the slump in profits, the 55% top to bottom fall in the share market has been disproporti
