Along with the rebound in the Australian dollar and commodity prices, prices within the materials sector of the Australian equity markets have lifted strongly in recent months. Indeed, the rise has come despite continued declines in forward earnings, with the result being that the sector’s price-to-earnings valuation is now at well above long run-average levels. As this note demonstrates, while high valuations do not necessarily suggest sector prices can’t rise further from here, it would require a relatively heroic rebound in commodity prices.
The materials sector has enjoyed good price gains in recent months. Since bottoming on February 3, the S&P/ASX 200 Materials sector (largely comprising major mining stocks) has lifted by around 37% by the end of last week. The rebound has clearly reflected the strong rebound in iron ore prices and improved sentiment regarding the Chinese economy. Of course this begs the question: has too much good news already been priced into the market.
As seen in the chart below, based on current sector forward earnings by end-April, the sector was trading at a price-to-forward earnings ratio of around 23.5, which is well above its long-run average of 13.1. Indeed, sector valuations are now even higher than at the previous valuation peak of 20 times forward earnings in mid-2009. As it turned out, sector prices back then were still able to rise by a reasonable 8% over the year to mid-2010, though only because of a fierce rebound in forward earnings and commodity prices as the global economy recovered from the financial crisis.