With the Australian stock market having appreciated by as much as 80% since early 2003, some of the normal fears about it being overvalued are emerging. However, there are some signs that this latest market cycle is more solidly based than ones we have seen before. 

There is no sure-fire way to judge whether a market is too expensive or not.  One can use historical valuation benchmarks based on earnings or compare values across international markets. There are always reasons why some will say that this cycle is different.  What constitutes a reasonable price at a point in time is so often in the eye of the beholder.  

thebigpicture uses a macro model as one guidepost to Australian market value .  The model is based on the interaction between economy-wide profitability, growth rates and long term interest rates.  It effectively puts a value on Australian profitability before comparing it to how the market has moved.   

Part of the usefulness of the model comes from there being over 35 years of data behind the analysis so that it does offer some perspective.  On the other hand, the data are from economy wide sources and, therefore, not confined to the stocks which make up the market indexes about which we are trying to draw conclusions. 

The output of this model shown in the chart indicates that it is a longer term indicator sending out ‘buy’ and ‘sell’ signals every few years rather than over weeks or months. 

The chart highlights four earlier market cycles:

In each case, the model signalled that the market was paying too much and, in each case, the market subsequently declined and stayed lower for at least a year.

By 2000, the model was suggesting that the market was overvalued.  However, since then, bond yields have tracked lower and average growth rates have moved higher.  The market took some time to recognise this favourable confluence of events which gave it the impetus to move much higher. 

However, despite its robust response, the changed conditions still seem to have been inadequately reflected in equity prices by the standards of past history. 

This marks out the current cycle as being very different to those earlier cycles in which market movements powered ahead of underlying conditions leading to sharp reversals or subsequently prolonged periods of poor performance. 

The greater caution being shown by investors  implies some reticence to accept prevailing growth rates or interest rates as being ongoing.  A big enough cut in anticipated growth rates or higher interest rates would close the gap.  Having either of those things happen is a risk from investing at current prices.   

Whatever ones judgment of the chance of those risks being realised, however, at least one thing is clear.  There would have to be a substantial reversal in these highly favourable conditions before this particular set of guideposts begins to imply that the market is overvalued in the sense that it was in 1987 or 2000, for example.

The announcement by George W Bush of fresh initiatives to develop oil replacement technologies could change the petrol price landscape - unless it is just another stick with which to beat his enemies. 

Oil price forecasts, like most financial market forecasts, continue to largely reflect a history of prices trading between $10/bbl and $30/bbl.  The consensus for long term prices of around $18/bbl has risen to around $25/bbl, nothing too outrageous but something a little more bullish to reflect recent price moves. 

At the back of the minds of many forecasters would be the experience in the 1980s when a combination of conservation measures and weakening global growth caused oil demand to fall and prices to plummet toward $10/bbl.  These days, with current prices influencing views, the upside risks are looming larger with some $100-plus scenarios being floated tentatively.  However, the mindset is still being set by what has gone before. 

thebigpicture showed in its issue for 10 October 2005 a connection between excess refining capacity and price movements.  The charts used to illustrate the connection are repeated here.  In essence, high prices have been associated with reduced excess refining capacity.  The inference is that capacity building investment in refining could once again reduce prices.  

Analytically, there are no reasons why prices cannot fall by a large amount and return to the range in which they had traded previously.  The record earnings of refining companies, and the supply of investible funds with come with them, might also make this more feasible.  By its nature, refining capacity investment is lumpy and likely to create excess capacity, at least in the short term, before it is subsequently used. 

Equally, prices could move a lot higher if the investment commitment is not made.  This could happen if refining companies happen to be too risk averse perhaps if they are unconvinced that adequate supplies of crude will be available to fill their expanded plants.  How much higher prices could go depends on how panicked markets might become if traders start to foresee looming shortages.  One hundred dollars a barrel might be a conservative call. 

Enter President George W Bush who called in his State of the Union address for the USA to reduce its oil dependence.  At its grandest, this could be construed as a call akin to President Kennedy’s quest to send a man to the moon and bring him back safely.  The comparison might be valid if President Bush galvanises government and business to act in concert to make the changes. 

Commercialisation of alternative energy sources could have far reaching effects on petrol prices.  An aggressive and effective programme could lead to longer term prices well below the currently expected averages.  This would be an especially likely outcome if a significant reduction in demand coincided with the opening of new refining capacity.  Such poor timing would not be unusual in commodity markets where supply-boosting  decisions often come with long delays causing the strongly cyclical price behaviour which typifies these markets. 

Of course, there is more than a hint that oil conservation alone was not driving the President’s call.  After all, his expressed concern was over "our dependence on Middle Eastern oil".  One suspects that the US government would be only too happy to continue to benefit from relatively low oil prices if the governments of oil exporting countries had been more compliant in their dealings with the USA. 

Unfortunately, it is not hard to tag the State of the Union initiative as simply another attempt to attack regimes unfriendly to the USA rather than being a genuine effort to bring about a fundamental change in domestic behaviour.   

If the argument about energy conservation becomes too entwined with one about the conduct of the US government in the Middle East, meaningful progress toward reducing oil consumption might be jeopardised.

Politicians are always keen to find ways to dictate corporate behaviour.  There are some interesting historical angles on their often forlorn attempts. 

The Australian Parliamentary Joint Committee on Corporations and Financial services is in the midst of an enquiry into corporate responsibility.  Behind this enquiry are terms of reference which boil down to whether companies should be concerned about more than financial outcomes in making decisions and, if they should, how that discipline can be enforced most effectively. 

The committee is considering matters that could have a considerable impact on company governance and investment markets.  The only reason its deliberations should be neglected is the poor record of parliamentary committees in forming public policy in Australia.   

One concern in the current exercise is that the politicians are behaving like they are striking out into new ground; that corporate governance is looming large for the first time giving them the chance to make some seminal decisions about the well being of society. 

Reading the transcripts of their deliberations prompted me to revisit some history which helps illustrate that, although the terminology might be different, notions like the triple bottom line and executive remuneration have had lives as long as the existence of the public company itself. 

After the English East India Company was founded in 1600, there were continuing tensions between its executives (in India), its directors (in London) and British political leaders wary about its political influence. 

One of the debates in 1813 when it sought to renew its charter to trade in India was about its role in the religious life of the subcontinent.  There were concerns in India that the company might be seeking to undermine the local Hindu and Muslim religions in favour of Christianity.  The company’s financial best interests would have been to eschew proselytising and its directors were arguing accordingly.  However, those without a direct financial interest saw converting the subcontinent’s population to Christianity as being very much a part of its corporate social responsibility. 

In the parliamentary debate on the renewal legislation, William Wilberforce argued that missionary access to India was “the greatest of all causes” and James Mill referred to Hinduism as “the most enormous and tormenting superstition that ever harassed and degraded any portion of mankind”.  The East India Company’s charter was renewed subject to these views being incorporated into its triple bottom line. 

Even as a caricature this example is a worthwhile illustration of the narrower purview of business interests and the far broader public policy agendas of politicians.   

There was no doubting the credentials of Wilberforce and Mill as forces for good in many ways.  There were reasons society could look to them for guidance about how its business leaders should conduct themselves.  But times change and today their views of what should guide corporate behaviour seem wholly inappropriate.  

Nor is political concern about executive remuneration new by these standards as a topic exercising the minds of our parliamentary representatives. 

In the 1750s, Robert Clive Governor of Bengal was under attack in the British parliament for what today might be called remuneration not connected to appropriate performance criteria.  His defence was that he was barely matching what his peers were entitled to receive: “I walked through vaults…piled on either side with gold and jewels.  Mr Chairman, at this moment I stand astonished at my own moderation”.  Despite some unease and some barely concealed envy, he was reappointed for another term with the politicians concluding that, all things considered, his approach was acceptable. 

thebigpicture is published by thebigpicture Economics (ABN 71 040 787 936). The author, John A Robertson, while working in Australia, London and New York, has had over 25 years experience in international financial and commodity markets, corporate strategy, financial and business evaluation and government policy.

As Chief Economist and a director of a leading Australian investment bank as well as a top-rated institutional equity analyst, he has marketed investment advice in all the major international financial centres.  As a professional economist, he was also a senior member of John Howard's personal staff when the current Prime Minister was Commonwealth Treasurer.

His work as a senior corporate finance executive in several public companies in the mining, consumer goods and IT industries complements a unique perspective in analyzing Australian companies and the environment in which they operate.

John Robertson provides investment advisory services to wealth managers including advice on asset allocation methodologies, portfolio construction and client communication programmes. He also advises companies on their capital market communications and financial strategies.

 thebigpicture is a weekly, independently authored review covering topics selected  from:

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Each article is written to provide decision making guideposts for private portfolio investors.

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