How expensive Australian stocks are, in two charts

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Stocks rallied into month’s end last Friday, but June has opened with a very different tone. So far this week the ASX has dropped 2.44% which has taken the quarterly performance to -4.34%.

Why sentiment can change so markedly in the space of a couple of trading days is difficult to fathom. Of course, the technical picture has turned a little sour.

It could be that Australian stock investors and traders recognise the message in two charts Business Insider noticed in Morgan Stanley’s excellent Australia Macro Monthly.

The first chart shows that the market rally has been based on expanding price to earnings multiples. That means that investors are willing to accept a lower return from the stock relative to earnings.

ASX 200 (Source: Morgan Stanley)

The second, and more worrying chart, shows that the expansion of PEs to this 15.96 level, one standard deviation from the average, is historically unsustainable.

ASX 200 PE’s (Source: Morgan Stanley)

There are a few ways to fix this. Companies can become more profitable, stocks could go nowhere for a while companies become more profitable or stocks could fall, contracting PEs.

Time will tell which one the Australian market experiences to get PEs back towards what might be considered a “normal” level.

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