While indicators such as relative strength or dividend yield or Elliott Waves are sometimes used to forecast where the sharemarket may be heading, there are other, perhaps less-conventional means of gauging whether equities are over or under-priced.

In the US, some of these “surprising” indicators include the “hemline-skirt length” indicator or the “Superbowl” indicator or the “lipstick” effect. In Australia, there are a couple of other ways of detecting whether the sharemarket is overpriced. The most telling is the “Today Tonight Effect”, which is exhibited when current affairs programs such as Today Tonight or A Current Affair feature stories on how regular people can make fortunes on the sharemarkets, perhaps by joining with friends to create an “investing club”. Another handy indicator is when mainstream business newspapers advice readers to leap into the sharemarket because the market is trading on a relatively low price-earnings (P/E) ratio.

This happened to occur last week, where Sunday Age columnist Richard Webb advised readers to delve into the sharemarket, in an article conservatively titled, Why our Shares are Ready to Fly. Webb appeared unequivocal in his advice, telling readers that “the stars are perfectly aligned for shares to rally hard to the end of the year”.

Webb noted that equity market experts claimed that “shares are 20 per cent undervalued”. This was because “the current forward price-earnings ratio on the sharemarket (a measure of value based on expected company earnings) is 11.5 times, against the long-term average of 14.5 times”.

Leaving aside the dubious nature of the E in a P/E ratio, there are certainly legitimate reasons for price-earnings ratios being slightly lower now than they have been in the past 20 years (more on that later). What’s more, the long-term P/E ratio isn’t necessarily 14.5 — that is the price-earnings ratio of the past two decades, an era marked by extraordinary credit growth and low inflation. Before 1995, it was not uncommon for market P/E ratios to fall below 10. A study of the US market indicates that over the past century, the US markets have averaged a PE ratio of about 12. (In 1980, not long after Business Week proclaimed the Death of Equities, the Dow Jones traded on a P/E of 7).

P/E ratios tend to climb during periods of high optimism (such as the dotcom boom, when US P/E ratios leapt to 32) — by contrast, during periods of high inflation (and higher interest rates), equity markets tend to exhibit lower P/E ratios. There are several reasons for this — first, businesses are often unable to increase prices quickly enough to keep up with costs, and second, during periods of higher interest rates, the yield provided by less risky bonds appears to be relatively more attractive. Currently, some investors anticipate higher inflation in coming years (potentially, after an initial round of deflation) — this is one factor causing P/E ratios to be lower than in recent years. Other investors believe that company earnings are likely to struggle due to global debt problems and the possibility of a US double-dip recession. That means that some investors think that the E, which is used to calculate the P/E ratio, is expected to fall.

Well-regarded fund manager Anton Tagliaferro was especially critical of the use of broad P/E ratios to determine whether the market is over or under-valued. Tagliaferro told the Financial Review that:

A huge proportion of the Australian index is in resource stocks, and it’s anybody’s guess what companies like BlueScope, OneSteel or Rio Tinto are going to earn in the next 12 months; the people with bullish forecast come up with low P/Es for those stocks, people like ourselves who are more cautious on growth come up with much lower P/Es … low market P/Es are used by brokers to spruik how attractive the market is, but in truth, they are nonsense.

Aside from a low P/E ratio for the market, Webb noted that another reason for anticipated sharemarket strength was, paradoxically, current property sector weakness. Webb noted the investors are bullish because “the property market is showing signs of faltering, following the rise in interest rates at the end of last year to May this year. This led to the sharpest rise in mortgage rates (from about 5.15% to 6.75%) in at least two decades, according to Macquarie Bank interest rate strategist Rory Robertson”.

Exactly how a weaker property market will translate to a strengthening sharemarket wasn’t explained by Webb — if anything, a collapsing property market will lead to a dramatic loss of consumer confidence (which will hurt consumer spending) and widespread asset deflation. This won’t be a good thing for Australian companies who would experience a sharp drop in earnings (like the US, consumer spending is the largest part of Australian GDP). Similarly, a deflated housing market will also substantially weaken the large banks profits (the four big banks are all among Australia’s largest companies) — about 60% of the big four banks’ assets are residential mortgages — they are ill-equipped to deal with a significant fall in the property market. Not only will the banks earnings fall, but the value of their collateral (largely residential property) will also slump.

Of course, it might not be all doom and gloom for equities. If Australian companies are able to generate sustainable earnings increases their share prices will eventually rise — however, those earnings rises need to be based on developing markets or improving efficiency, not cutting costs or relying on government stimulus.

And watch out for stories in A Current Affair.