It is clear that over the longer term what drives share prices is company profits. It is logical that the more profit a company makes, the more valuable it is and therefore the value of the shares increase.

The graph below shows company profits represented by the red line for the last 30 years. The green line is the value of the Australian share market measured by the All Ordinaries index. For the majority of the past 30 years the pricing of the share market has reflected company profits, until the Global Financial Crisis.

You can clearly see a disconnect between the red line and the green line which means that there is a clear disconnect between company profitability and the current share prices.

Ultimately we would argue that the lines will converge, and the most plausible result would be a significant rise in share prices.

Obviously the short term is dominated by the issues in Europe and the US, but arguably once these issues are resolved it is likely that the All Ordinaries index will once again be reflective of company profits.

We have provided another chart that demonstrates the point that the market is currently trading on fear rather than fundamentals.

This chart shows the Equity Risk Premium of the Australian Share market. Equity Risk Premium is defined as

β€œThe excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium.”

Generally speaking higher risk premiums result in lower valuations of assets.

What the chart below outlines is what additional premium investors require to invest in the Australian share market. This tells us that there is a very large amount of risk already priced into current share prices. The chart shows that the Australian share market is currently trading a 3 times the average Equity Risk Premium, which implies that the share market appears very cheap. The last time this chart showed such an extreme was in early 2009 – which was followed by a very strong share market rally.

Note: Advice contained in this article is general in nature and does not consider your personal situation or needs. Please do not act on this advice until its appropriateness has been determined by a qualified adviser. While the taxation implications of this strategy have been considered, we are not, nor do we purport to be registered tax agents. We strongly recommend you seek detailed tax advice from an appropriately qualified tax agent before proceeding. The information provided is current as at September 2011.

Published in Investment Advice