The Australian market recently hit fresh multi-year highs, which has triggered a debate about whether local stocks are overvalued.
There is no doubt there is some short-term risk in Australian equities, which was reflected in yesterday’s sharp sell-off after the Reserve Bank held rates steady. However we believe the short-term outlook is reasonably positive.
Investors also need to not just focus on short-term gyrations, but remember the remarkable long-term performance and wealth generation of Australian stocks, which a recent report has highlighted.

Will the bounce continue?

As the chart below shows, Australian equities have endured their longest bear market in history. But stocks have now surged close to 90 per cent off the bottom. We believe that if the country avoids a severe recession and interest rates continue to fall, over the next 12 to 18 months the market will continue to move up and make a full 100 per cent recovery.
Figure 1. Australian bear markets
Figure 1. Australian bear markets
Source. ASX

Is the Australian market overvalued?

The recent surge in local equity prices has been driven by interest rate cuts and M&A activity such as the Japan Post bid for Toll Holdings. Those gains have meant local equities are not as attractive as they were last month.
But are they overvalued?
We don’t believe local equity prices are at extreme levels. Investors should be concerned if prices rise more than 15 per cent above value. They should also worry if a local recession is looming. But we think a ‘muddle-through’ outcome – i.e. a slowdown of GDP growth but no recession – is likely in Australia and that will sustain asset prices.
Indeed, the table below shows that Australian shares are just one of two markets – along with UK stocks – that have a positive 12-month potential return. The yield on Australian stocks is also highly attractive on a relative basis, with a market dividend yield of 4.45 per cent.
Figure 2. Global equity price & value
Figure 2. Global equity price & value
Sources. MSCI Price Data

Second-best performing equity market

But investors need to also look beyond the short-term noise and focus on the bigger picture.
A recent report, ‘Credit Suisse Global Investment Returns 2015’, highlighted that the Australian stock market has been the second-best performing equity market in the past 115 years (from 1900) out of the report’s 23 countries, which cover 90 per cent of the global stock market.
Aussie equities generated a real return (the return you get after inflation) of 7.3 per cent per year. During that period, the annualised real returns of long-term government bonds were just 1.7 per cent and just 0.7 per cent for ‘treasury’ bills.
Figure 3. Australian equities, cumulative real returns (1900 - 2014)
Figure 3. Australian equities, cumulative real returns (1900 – 2014)
Source. Credit Suisse Research
The report also noted that, whether measured relative to bonds or bills, Australia’s equity risk premium (the level of return equities achieve over bond returns) is higher than for any other country in the report.
The message is clear that while there is some risk to investing in equities today, investors also need to remember the stellar returns that Australian stocks deliver with patience.
Indeed, we believe that over the longer-term there is more risk not being invested in equities.