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Tuesday, 21 June 2011 15:31

Financial markets are anticipatory animals

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How often have you seen a company make a record profit announcement, only to see their share price decline that day.  This happens as the markets had factored in a better result than was released, and that higher forecast was already built into the price.

Conversely investors often see share prices rise when companies announce bad news as the news was not as bad as had been built into the share price.

While this may seem counter intuitive to many, the fact is that financial markets are anticipatory by nature.  In other words, what is built into share prices takes into account information that is known as well factoring in forecasts of events expected to happen.

With this point in mind we look to the current pricing of share markets and ask why are they so cheap, when company earnings are rising?

The chart below tracks the average Price to Earnings Multiple (PE multiple) over many years to demonstrate whether the share market is cheap or expensive compared to history.  A PE multiple is simply how many times company earnings, investors are prepared to pay for a company.  Generally the higher the multiple, the higher the price of the company or market.

For example a company earns $1-00 per share, and its share price is $12, therefore the Price Earnings multiple of 12, but if the share price rose to $15 while earnings remained the same, the Price Earnings multiple would be 15.

 

 

What this chart shows is that the share market appears to have already anticipated the uncertainties in the world economy listed above by discounting the price earnings multiple it is willing to pay for companies (and in doing so reducing share prices)

Price earnings multiples are now trading at well below long term averages.

The key point is that markets seem to be already priced for many uncertainties in the global economy.  Investors need to ask whether the market is pricing in too much bad news as they were in early 2009.  If it turns out that markets are factoring in worse news than actually happens, investors could see share prices rise as a result of the market increasing PE multiples.

In the long term company earnings drive returns for investors in share markets, but in the shorter term numerous other factors impact share prices.

 

Read 988 times Last modified on Tuesday, 21 June 2011 15:32
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