Understanding the last 9 months

So we wake up one morning and it is October 1, 2009. We pour ourselves a cup of coffee and contemplate the Share market. Year to date your investment in shares is up 15.81%, your investment in cash is up 6.5% and inflation is at about 6.4%.

Now if you are like me you think about the future and ask yourself "what now?"

This is what flashes through my mind at that moment of asking the question:

Cash is killing me! (return wise that is). I earn 7% pre tax (4.2% after tax) and inflation is at 6.4%. That is okay for short term liquidity but what about the longer term, say 5 years from now.

Do I invest in shares at these levels? This I will only do if the price I pay for them now is still good value. A good way to determine the value of a share is to look at its Price/Earnings ratio (PE).

We have experienced what they call a "crash" in the share markets in 2008. An easy way to see how severe this "crash" was is to look at what happened to the PE ratio of the market and compare it to the long term average.

The 20 year average PE for the JSE All Share index in South Africa is 14. If the current PE ratio is below this average, we can say that the market offers good value and vice versa. In March 2009 the PE stood at 8 (market very cheap), currently it is at 13.5 and rising.

The increase from 8 to 13.5 is reflected in the 30% + rise in the share market from March. The question is, "can this continue?" The answer lies in the historic behaviour of the market.

2 Things happen after a crash. We saw this in 1961, 71, 76, 82, 88, 91, 98 and 2003.

First there is a Re-Rating of the share market. This is not a recovery based on a fundamental improvement in the shares like an increased earnings growth, but rather a reversion to mean. The 20 year PE mean is 14; it stood at 8 so it wants to go back to 14!

This reversion is lightning fast and unannounced. This time it happened at the beginning of March 2009 and is over. If you weren't in the market you lost this re-rating rally.

Secondly you get the fundamental recovery which is mainly driven by the earnings growth of companies. Investors will not continue buying a share from these levels until they are satisfied that the company will grow its earnings from current levels. We saw a 30% year on year growth for 4 years after 2003. The important thing to remember is that the PE ratio of the share does not increase substantially because the earnings growth matches the increase in the share price so the company with a 10 PE might increase its PE to 11 but the share might go up 20%.

After all this I can give you a short answer: The JSE All Share is still good value but the next 20% growth will take much longer than 6 months to materialise and will be driven by the recovery of company earnings rather than re-rating or sentiment.