Are Australian equities drastically overpriced?

We’re in the midst of one of the longest bull market runs in history. Despite all the doom and gloom, Grexit, Brexit, commodity price collapses and so on, the S&P/ASX 200 (INDEXASX: ^AXJO) (ASX: XJO) has enjoyed a relatively happy 7 years.

Yet history tells us that things could potentially be much, much different. Books like The Intelligent Investor (Ben Graham) and One-Up On Wall Street (Peter Lynch) report phenomena like 14% interest rates, Price to Earnings (P/E) ratios of 10, 10% dividends and so on that will sound outlandish to modern readers.

Looking for growth?

Lynch stated in the early 1990s  that growth companies are often valued at a P/E of around 17-20. Nowadays the ASX average P/E is around 17 times, and investors looking for growth companies are paying north of 30 times earnings. BWX Ltd (ASX: BWX) is valued at 33 times trailing earnings, and it’s not uncommon to see other fast-growing businesses trading north of 40 times. Bellamy’s Australia Ltd (ASX: BAL) was valued north of 50x its trailing earnings for quite some time.

Even companies like CSL Limited (ASX: CSL) and Carsales.Com Ltd (ASX: CAR) – valued for their perceived ability to continue to grow for many years into the future – have recently been valued at north of 25x earnings despite profits growing at below 10% per annum. While these companies’ prospects might justify their price, we can see that investors are clearly paying significantly more for growth than they did in times past.

How about dividends?

Shares in Sydney Airport Limited (ASX: SYD) and Transurban Group (ASX: TCL) have already started to plunge over expectations that interest rates could be heading up. These companies often behave like bonds in terms of pricing, because investors perceive their income stream to be reliable and defensive. Telstra Corporation Ltd (ASX: TLS) is another dividend stalwart that’s been sold off recently.

The sad fact is that as interest rates rise higher, alternative investments like savings accounts become correspondingly more attractive, reducing the appeal of equities. At the moment, shares are the only game in town for income-seeking investors.

Is the market overvalued?

Perhaps not, given the macroeconomic forces at work. Foolish contributors, other media outlets and fund managers wrote at length two years ago about how the exodus of savers from their savings account into the stock market was inflating share prices. 5% dividends plus franking credits looked pretty good compared to 3% in a savings account, and interest rates have fallen further since then.

Yet interest rates are now the lowest they’ve ever been, and there’s no prizes for guessing what would happen to share prices if interest rates headed back to 5%.

Foolish takeaway

One of the things that strikes me most about the USA’s history is how in a 10-year period, interest rates went from 5% to 14% to 5.5%. Or in Australia, from 5% to 8% to 3% inside of 5 years in the 1990s. If global stimulus is successful in igniting inflation and leads to a rise in interest rates, our current low rates could disappear quite rapidly.

Is there cause for concern? Not really – stocks should provide a more attractive long-term return than savings accounts or bonds, just as they’ve always done. Yet investors need to remain vigilant and be sure not to overpay in thinking today’s conditions will continue into perpetuity. They won’t.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia owns shares of Bellamy's Australia. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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