The great equities mystery

Brokers like to either sit on the fence or look like gurus. Let’s have a look at two examples of both. Citi is opintnig out that over the last two months, the Australian market has corrected a little more than the US and other major markets, partly a result of commodity prices pulling back and the risks there, but also it seems because of concerns about higher interest rates, particularly “when the economy doesn’t look that strong”. Earnings downgrades, a strong exchange rate and generally subdued business conditions have dampened confidence. The market is on a multiple of 11x consensus forward earnings.

Citi firmly takes up position on the fence:

The prospects for the market over the remainder of the year will, as always the case to a significant extent, be dependent on overseas markets, and a regaining of some momentum in US economy, as supply chain disruptions pass and the drag of oil prices lessens, along with reaching the end of the tightening phase in China, and some renewed resolution of sovereign issues in Europe, could all contribute to some rebound in markets, even if not as quickly back to levels in mid April.

In Australia, an additional help might be some easing in concerns about interest rates, as the Reserve Bank responds to the evolving economic data (even while maintaining its determined view on rates over the medium term), and the slowing in growth and employment and likely continued subdued underlying inflation, encourage an extension of the pause on interest rates, till late in the year or next year. This would provide some comfort the RBA’s approach remains realistic.

With events unfolding this way, we think the Australian market could work its way back to where it was in early April, taking the ASX/200 to around 4900 by the end of the year. But this target represents a downgrade to our previous expectations, which had envisaged the market moving to 5250. That was based on the expectation that stable interest rates, after the significant rise over the year or so to last November, would improve confidence, but that hasn’t happened, partly because of the continued talk about rates. FY12 consensus earnings also look at risk of further downgrades, perhaps in the order of 5%, which will also limit the market.

The Medium-term

Despite the reduction in our year end target for the market, it still offers potentially good returns from the current level. Looking beyond this, the continuing upside is, realistically, likely to be less, as earnings growth slows, with a peaking in resource earnings at some point, and subdued growth in many other sectors given the “two-speed” nature of the economy. Of some consolation is that other developed markets also seem to be facing moderating earnings growth, in the context of what our global strategist, Rob Buckland, calls the “Grind Higher”, even though they face a different set of challenges to Australia.
What remains is some potential for the market from an improvement in risk appetite and sentiment, which could see the market move back up to a higher multiple again, something we have had hopes about. But it’s looking increasingly unlikely, because households are essentially less comfortable with the debt they have, and prefer to pay it down or put their savings in the bank rather than the market, and this looks like being the case for a while. And the environment, with further rises in interest rates over time at home, and likely continuing headwinds and slippages in growth overseas, will probably reinforce the preference for caution.

Next step is to plump for a mid-range forecasting the ASX/200 to move up to 4900 this year and 5350 in 2012. 

Southern Cross takes the guru path, trying to pick the bottom in order either to crow about it later if things turn out well, or conveniently move on to the next stock pick if they don’t. But Southern Cross makes some good points about share marekt valuations:

Australian households have lost confidence and are in the most defensive/cautious mood since the recession of the early 1990’s. Fair enough, it is an East Coast recession and we have woeful political leadership in this country. Secondly, the RBA has done such a good job (see also bad job) of jawboning that households are convinced that interest rates are moving higher. They are paying down debt and putting money on deposit, all based on a view that interest rates are moving permanently higher (ps I am looking forward to reading the RBA Board minutes today). Thirdly, and most importantly to me, households have “thrown in the towel” on equities as an asset class, which just happens to coincide with the strongest valuation and fully franked dividend support in Australian equities in decades.

With FY12 commencing is just 8 trading days I thought it would be worth looking at the top 10 stocks in the ASX200, which alone represent 50.5% of the benchmark index itself, just to reinforce that you don’t have to go outside of our largest, long duration, high quality companies to see genuine deep value and yield support based off consensus forecasts for fy12 (which have recently been lowered).

Either the world is about to end (again), or there is deep contrarian investment value, income and leverage in these names. You are being paid a big premium by “Mr. market” to take a risk, but the real investment risk (in terms of losing your capital) on these multiples is very low.

The real uncertainty remains the housing market for the domestic economy and China for mining. Of the two, I think I downturn in housing is far more likely but a downturn in China would be far more harmful. Probably the best answer is high dividend yields. Southern Cross again:

Right now if you have cash your purchasing power in equities is unprecedented. I actually think the value and yield we see before us today is a better risk adjusted buying opportunity (in the right stocks) than the peak of the GFC. Why do I think that? Because at the peak of the GFC the world really could have ended financially. We were one minute to midnight, yet now that default risk has been transferred to the government sector from the corporate sector making recapitalised equities the lowest real risk investment on earth. Buy a US 10yr bond at 2.95% or buy National Australia Bank (NAB) on a 7.7% yield. You know what I recommend.
Shares are treated as capital gain plays, but they are supposed to represent the present value of future earnings, the present value of future dividends. As the world discovers the consequences of excessive leverage, asset fiddles and various other absurdities, maybe we are returning to those more traditional days.

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  1. I assume its Charlie Aitken at Southern Cross?

    Mid afternoon action is pointing to an impulse rally – most of the ten stocks listed above are showing short term bottom accumulation patterns.

    The dovish minutes helped – even though the index is correlated with interest rates (i.e the higher the rates the higher the index goes, using monthly averages)

  2. Dividend yeilds look good, at least until the next earnings forecast.

    What do you think the next earnings season will have in store SoN?

    • High dividend yields do not necassarily equal high dividend income over time. You should never invest in a stock just because it is offering an attractive yield.

  3. hmm.. long term valuations based on forward consensus earnings forecasts. Every piece of research I have seen suggest there is very little to NO empirical evidence that anything to do with consensus earnings forecasts represents a reliable forecast tool?

    “but the real investment risk (in terms of losing your capital) on these multiples is very low.”

    Really, happy to believe this if we had something more to than consensus earnings to base it on. Once again, is there some empirical data that suggests equities with forward earnings multiples and yields as at today have provided solid returns, with limited downside risks over statistically meaningful time frames in the past??? If not then I cant see any reliable basis for such a claim (but as the author suggested, the basis is irrelevant as the forecast will be remembered only if it proves correct)

    And as far as broad market forecasts are concerned….. I was shown a table from the AFR in July 2010 that had the ASX200 forecasts for June 2011:

    Deutsche Bank 6250
    UBS 5800
    Citigroup 5500
    Goldman Sachs 5375
    Macquarie 5068
    JP Morgan 5000
    Morgan Stanley 5027*
    Credit Suisse 5000*
    Merrill Lynch 4500*

    Noting that * = forecasts were for Dec 2010 as they had not given July 2011 forecasts!

    So tell me, what about the world is less certain today than it was 12 months ago? Euro issues.. commodity prices, stability of corporate profits/earnings, US/Euro economic data? Chinese growth……. Nope, they were all pretty well uncertain then (perhaps more so) and correct me if I’m wrong but I can’t recall any true black swans between then and now?

    Something tells me I could produce that table over an over again for any time period in recorded history and the results would be the same! And o that note I have said enough on the accuracy (& value) of industry ‘consensus’.

  4. The market may be on “a multiple of 11 x consensus forward earnings”, but when you get up close to a lot of the higher-rated stocks, the multiples are significantly steeper than this.

    And if, like me, you look at sustainable dividend yield first and P/E second, then clearly many stocks are still priced for solid and prolonged growth. Whether they can achieve this growth is another thing entirely.

    Given the outlook for GDP, there are very few sectors likely to turn in, say, secure 5-6% growth in even nominal earnings from 2012 and beyond. And yet the pricing for leading stocks seems to be relying on earnings and dividend growth running to 7,8,9% or more for the foreseeable future.

    For sure, there are some stocks that have good growth potential, based on real income expansion over 1-5 year time frames, but you have to look hard to find them.

    And if you use a discount rate for equity investment that reflects the risks of being in the stock market rather than in cash, then it gets even harder to find worthwhile prospects in the Australian market.

    So the index is exhibiting a lot of tension between the desire for yield and aversion to risk, and the result is a market that is traveling sideways. This motion will continue until the outlook for the economy and profits becomes easier to read.

    • “This motion will continue until the outlook for the economy and profits becomes easier to read.”

      I don’t think the outlook ever gets easier to read. People just think it does.

  5. QC, I don’t think I am making any big calls by saying that earnings downgrades are in the offing.