The World Economic Forum published research, which shows SA to have the highest misperception score in the world in respect of people’s incorrect perception of what is going on versus reality.
Like any statistic there is a risk of misinterpreting / misrepresenting the research; but the point I want to make is the influence our emotions can have on rational decision taking, which I will expand on related to valuing the stock market.
The long-return of the stock market is simple to illustrate as it is made-up of three components for which we have accurate data:
What is evident when forecasting returns for next 5 yrs. is the fact that the JSE earnings (dividends) and earnings growth are expected to be much the same as the past 14 yrs. The difference is an anticipated re-rating of 3.5% from current levels. The re-rating or de-rating component refers specifically to investor sentiment. When investors are positive they are willing to pay a premium for shares expressed as a multiple of earnings i.e. P/E 15X (overpaying) and when they are negative multiples fall to single digit offers i.e. P/E 8X (underpaying). What is interesting is the fact that the rating component added very little to the total return from 1994-2018 with highs offsetting lows.
The reference to double whammy is the fact that when investors are negative you have both depressed earnings and lower ratings and when investors are positive earnings are high and investors are happy to pay higher multiples for the higher earnings.
This is the reason markets always overshoot on the high-side and undershoot on the low-side, owing to the double whammy effect of under or over estimating long-term earnings based on spot prices and applying an overly optimistic or pessimistic multiple to the earnings number i.e. unsustainable high earnings are incorrectly rewarded with a high multiple while unsustainable low earnings are punished with a lower multiple.
It is a well-documented fact that earnings always revert to mean i.e. above trend earnings don’t last forever just as below trend earnings recover. There is a simple economic principle underlying earnings revision, which relates to competition. If a business is making above average profits it attracts competition, which then erodes profits for everyone and likewise a struggling business where the competition is failing will see profits of the survivor recover.
The smart investor will use long-term average earnings to value a business and disregard the current spot earnings while applying a reasonable multiple and not one influenced by current market sentiment.
We currently have depressed earnings and negative investor sentiment i.e. the double whammy affect, which is why share prices over the next 5 yrs. are likely to benefit from a re-rating driven by an earnings recovery and improved investor sentiment.
Fact check your perception vs. reality and then engage your rational brain when making investment decisions.
Mcomm, CFP®, HdipTax
T. 021-851 3746