The Australian equity market has enjoyed a few good months, though once again it is now facing valuations challenges. Irrespective of how the market deals with this challenge, income returns from the market remain very attractive relative to interest rates. Given that local interest rates could fall even further in coming months, this suggests that the high yield equity theme is likely to perform relatively well in most market conditions. There’s even a chance that the equity market could be “re-rated” higher if interest rates remain below historic average levels.
As seen in the chart below, the S&P/ASX 200 has staged a come back in recent months, and is again trying to push through 5400 points. The challenge, however, is that the rise has come despite continued weakness in forward earnings, such that the market’s price-to-forward earnings ratio has again increased to the peak of just over 16x seen in early-2015 when the market last ran out of steam. In fact, market prices remain lower now than in early 2015 – despite similar PE valuations – due to a decline in forward earnings over this period.
On some other measures, however, the market is arguably less overvalued – and potentially cheap! As seen in the chart below, according to Bloomberg estimates, the market’s gross dividend yield (GDY) as at end-May was 6.1%, which is significantly above the approximately 2.5% p.a. rate available on 10-year government bond yields and 1-year bank term deposits.
Does this mean the market is cheap and should simply surge in value to bring down the dividend yield?
Relative to earnings, the current level of dividends appears unsustainable – either earnings will rise and/or dividends will tend to fall to restore a more normal payout ratio.
Given that dividend yields remain so high relative to interest rates, however, they are likely to remain attractive even if they’re cut to some degree. Let’s assume, for example, that earnings hold around current levels for some time, and dividends are eventually cut by 20%, that would imply a decline in the GDY to 4.9%, which would still imply a substantial 2.4% p.a margin over current 10-year bonds yields and one-year term deposits.