Valuations

Each month (or intra month, if the moves are large enough) we check in with estimates of the equity risk premia, which, over long periods of time, is what chiefly compounds wealth across our domestic and international equity allocations.

High ERPs indicate high ex-ante returns, a material degree of compensation for taking on equity market risk, and low ERPs indicate the opposite.

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The ERPs above are calculated using a variety of different models (input assumptions) by Aswath Damodran. The general point is that shares are broadly expensive on a majority of frames.

Using a Shiller PE derived ERP (another model, which normalises for earnings over a full business cycle, and normalising for changes in potential output growth rates), and lumping it in with the Damodaran mix describes a similar picture, with a slightly higher print relative to the grouped average, and perhaps at the margin reduces valuation anxiety, and by way of comparison to history.

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To us, the implication is that the ERP is high enough to meaningfully help diversified investment portfolios contribute to their SAA objectives. Exaggerating slightly, with bond yields (or more precisely, risk free rates) so low, there’s isn’t much alternative (which gives rise to TINA, there is no alternative) to allocating capital to shares to receive the ERP.

But on a DAA basis there is likewise good reason to use the above signals to moderate the SAA exposure, with a modest tilt away from equities (in our multi asset portfolios, this means an underweight to Australian and international equities).

The DAA underweight can blunt the impact of market reversal, but the SAA position means that the return objective has a better chance of being satisfied than a portfolio that sits in cash.

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This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

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