is it 1987 all over again?/shares article

An excerpt,

This year is likely to be a good one for investors in the Australian sharemarket even though all know that the past 12 months will be hard to emulate. The All Ordinaries index recorded a total return (income plus capital growth) of almost 28% in 2004. A repeat performance would see it rise from about 4000 in December 2004 to 4800 in December 2005. How likely is that?

In chart 1, showing movement in the All Ordinaries index over the past 20 years, the strong rise of the past two years stands out clearly. Indeed, it invites us to compare the past two years with the market rally that preceded the October 1987 market crash. To underline the similarity, the total investment return since the start of this bull market in March 2003 has been about 45%, the highest two-year return since the run up to October 1987. This comparison is obviously worrying.

Charts, however, can be endlessly misleading. Chart 2 shows the same data as chart 1, but is scaled in logarithmic terms so that percentage, rather than absolute, changes are treated equally. In this more meaningful perspective, the All Ordinaries index tells a less ominous story. The 45% investment return of this bull market is impressive, but in the two years preceding the October 1987 crash the All Ordinaries index rose by 130%. The recent market performance has indeed been strong, but nothing approaching the boom of the 1980s. And market valuations in 1987 and 2005 are quite different. Chart 3 shows that in September 1987 the sharemarket was on a price-earnings

(p/e) ratio of 21.1 times earnings - this at a time when official interest rates were above 10%. At present the market p/e is about 15.1, near the low end of its 10-year trading range and with the official cash rate at 5.25%.
Ironically, the market index is close to record highs, but the overall sharemarket is not expensive, at least when benchmarked against the p/e. In fact, the low p/e is one of the strongest arguments for expecting another big year on the market in 2005. A second encouraging pointer to 2005 is the expectation, by economists and company analysts, that corporate Australia will report another year of strong earnings growth in 2005.

Let us run some back-of-the-envelope numbers. Factor in company earnings-per-share (EPS) growth of about 9% for 2005. This number is close to the consensus forecasts of company analysts of the major Australian brokers. Suppose the market p/e remains at 15.1, then, driven by earnings growth alone, the All Ordinaries index will be about 4350 in December 2005 and investors will enjoy total returns of about 14% if we add about 5% to take account of dividends.

Consider a second scenario: company analysts are hopelessly wrong. Earnings growth is a modest 2.5% through 2005 - no more than the expected inflation rate. Suppose, however, that the p/e reverts to its 10-year average of 17.3. Then the All Ordinaries index will be about 4700 in December 2005 and investors can expect a total return of about 22.5%.

An alternative, pessimistic outcome sees the All Ordinaries at 3500 at the end of 2005. Supporters of this gloomy view are presumably willing to contemplate a market p/e of about 12.5 or lower (certainly the lowest level since the 1990-91 recession) and need to explain why economists, company analysts and the companies that provide guidance to analysts have almost universally got their forecasts wrong.

None of these outcomes is inherently impossible. None would take company earnings growth or price-earnings valuations into uncharted territory. And we do know that the sharemarket seldom runs according to plan.

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Full article at,

http://www.sharesmag.com.au/stories2/20050201/23183.aspx