Taken from PowerStocks Research, this is the first of 3 methods I’ll take you through that show how to use the daily JSE trailing Price/Earnings ratio to manage risk in your investing and/or trading decisions. The P/E ratio is a valuation ratio of a company’s current share price compared to its per-share earnings, calculated as:
Market Value per Share / Earnings per Share (EPS)
For example, if a company is currently trading at R43 a share and earnings over the last 12 months were R1.95 per share, the P/E ratio for the stock would be 22.05 (R43/R1.95). The JSE’s P/E ratio is merely the same calculation, but conducted on the sum of all its constituents (over 350 shares). It thus gives the aggregate P/E ratio of the whole South African stock market. However the JSE market capitalization is dominated by the top 40 large-cap shares (it is very "top heavy") and so in reality these 40 shares’ earnings will likely dominate the overall JSE’s P/E ratio.
When a P/E ratio is low, the shares’ (or market in the JSE’s case) are considered to be cheap. When the P/E is high, it is considered expensive. Clearly buying the JSE (through a SATRIX-40 or other ETF) when it is cheap is less risky than buying the JSE when it is expensive. We present a number of tools using the JSE overall P/E (of the whole market) to gauge your market risk.
METHOD-1: JSE VALUATION TO MEAN
P/E’s are considered "mean reverting" meaning they fluctuate around an average. If the P/E is far above average, "gravity" will eventually pull it back to the mean, which will require a correction in the JSE. With stock markets, P/E’s never trend toward the mean they fluctuate wildly about the mean - since stock market corrections (panic) and bull markets (greed) always tend to overshoot. The JSE TOP40 and its trailing P/E are shown below since 1996 to illustrate this:
We use a linear regression mean (black dotted line) to show the long term "average" of the P/E as opposed to a single straight line as clearly P/E’s have been trending upward over the decades. The red line is 2 standard deviations above the mean (way above average = expensive) and the green line is 2 standard deviations below the mean (way below average = cheap territory.)
Mean reversion dictates that overly high P/E ratios (over-inflated prices) will eventually succumb to the laws of supply and demand and revert back to the mean. If you can find points in time where the P/E level is over-extended (above red line) or under-extended (below green line) this can give you some idea about how risky the market is. Over-extended P/E ratios are risky and warn of a correction whilst under-extended (low) P/E’s actually are lowest risk entry points. Ironically market sentiment at these points is counter to the implied risk. Very low P/E’s arise out of financial crises, recessions, sell-offs, panic and general bearish sentiment. The perceived risk is high but the actual entry risk is low.
You can see that whilst not every visit by the P/E into expensive territory resulted in a correction, and not every correction was preceded by expensive P/E’s, there are some pretty nasty corrections that had expensive P/E’s fingerprints all over them (red circles). More importantly, every visit of the P/E into "cheap" territory served up magnificent buying opportunities (green circles.)
The relationship of the TOP40 P/E ratio to its regression mean therefore provides an excellent guideline to inherent market risk. As a rule of thumb the JSE is not a very safe place when P/E’s are above the red (expensive) line and is presenting massive buying opportunity when it is below the green (cheap) line.
PowerStocks subscribers can see the P/E regression chart updated on a daily basis as shown below in the CHARTS MACRO P/E menu. The black solid line is the daily P/E ratio and the chart is shading red when the P/E rises above the "expensive" red regression and shading green when it falls below the "cheap" regression trend. We also show a blue line which is the J200 index divided by its P/E ratio to derive actual earnings per share for the TOP40’s underlying constituents. This allows you to track on a daily basis if any company earnings announcements increased or decreased index earnings.
In the below example you can see a sizeable correction in the J200 against a backdrop of rising per-share earnings (the blue line). This would have triggered a BULLISH EARNINGS COUNTER TREND alert. In addition, the J200 P/E dropped below the "CHEAP" regression line and green shading appeared on the chart to show a rare cheap buying opportunity. The rising earnings coupled with the unusually cheap valuation was your cue we were onto a winner here - the market rose 8.5% in the ensuing 3 months, 16% in the ensuing 6 months and 25% in the ensuing 9 months.
Charles Collocott, CFA
CFDs & Securities Manager, Sharenet
You will be hard pressed to find someone more qualified than Charles to assist you with seamlessly interacting with the markets through Sharenet’s Securities and CFDs trading platforms. Charles began his career in 2006 as a trader at Peregrine Equities, South Africa’s leading prime broker and has also been a trader at Legae Securities as well as a buy side trader and part time market and stock analyst at Cannon Asset Managers. In addition to being a CFA charter holder, Charles also has an undergraduate degree in Politics, Philosophy and Economics from the University of Cape Town.