NEXT CHAPTER    --> | Relationship between JSE ALSH Index P/E and 6-month returns |

RELATED TOPICS --> | Relationship between individual share P/E & subsequent returns |
                               | Best performing P/E ratios since the 2003 Crash |
                               | Regression Charts for individual ALSH Index PE ranges |

For over 100 years investors have looked at a shares' Price-to Earnings ratio (P/E ratio) to determine how expensive or cheap it is. This important ratio depicts how many times you are willing to pay for 1-years earnings of the share. It is the price for the share divided by the previous reported years earnings per share. If a share has a P/E of 15, it means you are paying 15 times a single years earnings for the share.

We have already demonstrated the strong relationship between returns and individual shares' PE in previous research (see related topics above.) We have also shown strong performance from strategies that use share P/E such as our very successful Magic Formula strategy which uses low P/E combined with high Return on Capital to choose shares.

However, with this research note we aim to use the daily published overall JSE ALSH Index P/E ratio to determine a relationship with ALSH index returns. If we could establish such a relationship then we could look at the overall JSE P/E and make determinations as to how expensive or cheap the overall market is as a whole as well as make informed observations about expected returns and risks of a correction on our investing activities.

1. FIVE YEAR RETURNS EXERCISE
The chart below shows the 60-month ALSH returns for historically observed end-of-month ALSH Index P/E's for the last 16 years (192 observations.) For the long-term investor, the message is clear that there is a very high correlation between P/E ratio and subsequent 5-year returns.



You can use the yellow regression line to predict with relatively high confidence what the likely return of the JSE will be within 5 years for any observed P/E  ratio. You will need at least 35% return over the 5 years to just keep up with 6% inflation, which implies that ideal P/E ratios should be below 17.5.

2. TWELVE MONTH RETURNS EXERCISE
The chart below shows the 12-month ALSH returns for various daily observed P/E's for the index for the last 16 years (over 3,825 daily observations since 1994.)



LEFT CHART : The green vertical bars correspond to the Y-axis on the right side of the chart and the other lines correspond to the Y-axis on the left. The blue line represents average appreciation (growth) in the ALSH 12 months after the date of occurrence of an observed P/E range, whilst the green bars represent the % of those growths that were positive. The black line is a close-fit trend-curve of the blue line. The yellow line depicts a near perfect normal distribution of historical P/E values over 16 years.

RIGHT CHART : This is a scatter-gram of all the daily P/E observations (on the x-axis) versus subsequent JSE returns 12 months later (y-axis). The yellow line is a least-squares regression line depicting a -0.21 correlation between PE and subsequent growth.

MOST COMMON : Looking at the yellow line in the left chart, we note that PE's ranging from 14-15 are actually the most common, occurring approximately 18% of the time with a 76.8% probability of a positive return after 12 months. The average return is 16.2% with a standard deviation of 21.8% (standard deviations not shown) to give a Sharpe ratio (average/deviation) of 0.7, so returns seem rather "volatile" during these times.

SURE THING : The second important observation is that investing in the JSE when P/E's are less than 10, whilst infrequent occurrences, virtually guarantee positive growth after 12 months. In fact, even when P/E's are in the 10-11 range the chances are 94.3% that investments during these periods will yield a positive result. The average returns, deviation and Sharpe ratios for the "low PE" ranges are depicted below. Together, these 3 ranges only account for 8.6% of all observations made meaning they are very rare events indeed. The very high Sharpe ("SHP") ratios show how incredibly consistent the returns are from investing during these periods.



PLAYING WITH FIRE : Note how investing in the JSE when P/E's are 20 or more offer you less than even odds of making a profit - not a place you want to be unless you like gambling and when the odds are stacked against you! The table below shows the data for the "High PE" ranges. Together, these 3 ranges only accounted for 6.3% of all observations meaning they are also very rare events. The first two have very low Sharpe ratios (big deviations relative to their returns) meaning they are "risky gambles" that could swing wildly in returns and offer even larger losses than the average returns. PE's ranging above 21 have a high Sharpe ratio depicting very consistent negative returns meaning you are virtually guaranteed to make a loss after one year, with a 88.9% probability.



SWEET SPOT : The "Sweet Spot" seems to be a P/E range of 17-18 since this offers a 91.3% historical probability of positive returns after 12 months whilst averaging 12.0% returns across all 298 observations (7.8% of the sample.) Incidentally this average return has a standard deviation of 11.4% yielding a Sharpe ratio of 1.1, the highest Sharpe ratio of all positive-return PE observations ranging from 11 to 19.



WATCH THE CLIFF! Note how things quickly go pear-shaped when the JSE ALSH index's PE hits 18 and above. The average return plummets to 2.5% and the deviation of returns swings wildly by 11.2% to give a dismal Sharpe ratio of 0.2 from the previous brackets' 1.1! Percentage positive results also plummets from 91.3% to 64.6%

DEVIL IN THE DETAIL! Assuming we are at a current published P/E of 17.9 for the ALSH index, we cannot safely assume we have a "sure thing" by investing in the JSE, despite the fact that a P/E of 17.9 falls within the 17-18 "sweet spot" range. We actually have to look into the detailed regression chart (also known as the scatter chart) of the P/E range itself, as shown below:



We see that the correlation between P/E and 12-month returns within the 17-18 band is virtually identical to the entire sample set, but that an observed P/E for the ALSH of 17.9 is only likely to deliver 7.5% return within 12 months (where it intersects with the yellow regression line.) So within the "sweet spot" range of 17-18 P/E, which promises to deliver 12.0% return on average, the actual return has historically averaged from 15.1% to 6% depending on the P/E value.

SUMMARY : The blue line in the left chart at the beginning of Section-1, together with its black close-fit curve tell the real picture  - depicting that investing during times of lower P/E's truly offer greater average returns coupled with fewer occurrences of losses. This is collaborated with the regression curve in the right chart showing correlation of 0.21 between PE and subsequent 12-month returns.

In fact, average 12-month returns of investments in the index made when P/E's are 20 or more average out at negative returns. We could deduce that it would not be statistically wise to invest in the ALSH index when its P/E starts exceeding 18 since even though the odds of a positive result are 60-65%, the average likely 12-month returns are only 2.5% and your money would be better off in a money market or fixed deposit.

When comparing daily observed JSE P/E Index ratios with PE ranges in the said charts, one must also inspect the individual regression charts (scatter-grams) of the range in question to gain a more accurate depiction of expected future returns. If you are a PowerStocks PRO subscriber, you have access to these individual charts to make your comparisons and estimates.

2. SIX MONTH RETURNS EXERCISE
The 2nd instalment of this research piece looks at a similar 6-month returns exercise for various daily observed P/E's for the ALSH index for the last 16 years (over 4,034 daily observations since 1994, slightly more than the previous section.) Six-month returns have an even higher correlation to P/E ratios than 12 month returns, but the profile of returns to the various P/E ratio ranges differs somewhat (different "sweet spot".) You need a subscription with us to be able to access the link.

CLICK HERE TO GO TO CHAPTER-2 --> SIX MONTH RETURNS EXERCISE

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NEXT CHAPTER    --> | Relationship between JSE ALSH Index P/E and 6-month returns |

RELATED TOPICS --> | Relationship between individual share P/E & subsequent returns |
                               | Best performing P/E ratios since the 2003 Crash |
                               | Regression Charts for individual ALSH Index PE ranges |
 
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