Buy, sell, buy!

Brokers are predictably divided over the ructions in the market. In theory the declines should add up to some buying opportunities, but bear markets, and that is surely what it now is, are notoriously hard to pick. The big question in this a cycle — i.e. is there enough that constitutes a reliable centre around which markets can revolve — or is it something far more serious that threatens the markets themselves? Are the market worshipers about to discover their god is made of clay? Brokers incline to the former interpretation, which is hardly surprising. They are detail guys; it is harder to calculate the net present value of the big picture.

Merrill Lynch thinks the local market is cheap:

The ASX 200 has fallen 17% since its peak in April this year, to 4105, and is now significantly below our fair value estimate of 4700. In this note we have screened for stocks that could rebound the most on attractive valuations. We set the bar very high and screen only for stocks whose valuations are cheaper now than at the equity market trough in March 2009.

The most stringent screen

We were surprised by the number of larger stocks that currently had a lower PE and a higher dividend yield than at the height of the financial crisis. In energy this included STO and WPL, in financials IAG and IFL, in consumer WOW, TEN, JBH and TTS, in materials NCM, MGX and ILU. Other stocks included CSL, TOL and AGK.

Protection from a policy response

The cheap valuations of quality consumer stocks is interesting because they potentially stand to benefit from policy responses that might occur if global conditions weaken further. During the financial crisis these included direct payments to taxpayers, lower interest rates and the first-home buyers grant. A fuller list of stocks that would benefit could benefit in a similar scenario include:

  • Low-end retail (WOW and WES through Big W, Kmart etc) which benefitted most from the direct payments last time.
  • Gaming (TTS and TAH) as the money leaks into pokies and gaming.
  • Developers (particularly SGP) that have the low-end developments that would benefit most a home-buyers grant.
  • Media companies with less structural headwinds (TEN and SWM) that would benefit as retailers scramble to capture the money.

UBS is pretty cautious on the global outlook, however:

  • Revisiting our base case for earnings and markets

With ongoing market turmoil we revisit our base case assumptions for global earnings & market returns. While growth expectations have come down, and the European sovereign situation remains precarious, our global economics team continues to forecast a reacceleration of global growth.

  • Scenario analysis supports cautious stance

While our base case does point to 10-15% market upside, given the considerable uncertainty with regard to potential economic outcomes, a scenario-based approach is warranted. Our analysis implies that markets are not pricing in a recession, and on a probability-weighted basis, more subdued return expectations lead us to continue to recommend a more cautious stance.

  • Seek quality and maintain balance

We do not recommend investors add to risk here. The probability of our downside cases have increased and the outcomes are quite severe. We therefore continue to recommend that equity investors seek high quality stocks across a balanced cyclical/defensive portfolio.

  • Regional allocations

We believe Emerging markets should outperform in most of our scenarios given stronger growth prospects, healthier balance sheets and lower valuations. And despite looming risks, given the large valuation gap, we also see the relative risk/reward skewed to the upside for Europe.

RBS is mildly bullish and advises some rotation:

Short-term concerns into reporting season should give way to positive fundamentals.

Given our expectation that the current soft spot in global and especially US economic data will give way to resumed momentum in 2H11, we maintain our pro-cyclical stance in the RBS Model Portfolio.

  • Tactical rotation from utilities into banks

We rotate from an overweight position in Utilities via APA Group to zero weight in order to fund a position in Westpac. Also, given CBA has modestly underperformed relative to the sector, we also reduce this holding to fund the Westpac position as we see greater relative upside potential in the near term. This takes our Banks weighting to +3.5% from neutral. We had expected the banks to underperform last month and, accordingly, had moved from an overweight to neutral position. The speed and severity of the correction means that Westpac in particular is now offering above 7% yield and capital appreciation in line with earnings of 7% in FY12F. We see a catalyst for a refocus on the banks through a resolution of the Greek sovereign debt issue in Europe at the EcoFin meeting on 20 June. Utilities have outperformed the S&P/ASX 200 by 2% ytd and, given our more sanguine view of global economic growth, we see this sector as a funding source currently.

If you think the brokers are right, take your pick. Australia certainly seems well positioned compared with Europe and America. Strong cash flows and high dividends seem the best plays. Buy on weakness, as the cliche goes. But, be aware that in this policy driven market, it might be more wise to wait for an intervention trigger.


  1. thanks for the timely post.

    it is another interesting time to “test” investment philosophy.

    I have always been on the “value” side, but with caveat:

    — if you can’t tell which cycle you are in, stay out

    — always sceptical on “valuation” – it is a dark art

  2. The risks in 2008 were private liquidity/insolvency. The balance sheets of major US companies appear to be in better shape but let’s remember that many banks in the USA are protected from insolvency at the moment due to the a change in FASB 157 in April 2009 that allowed mark to fantasy of their mortgage books. The problem is that house prices have not recovered and will not for many years so there are still some question marks over banks IMO.

    Overall though you’d say that despite all the problems in the USA it is in better shape than 2008 and there seems to be less known unknowns.

    Europe on the other hand is much worse than in 2008 but since this is sovereign the ultimate solution is monetization, if it comes down to that. So inflation becomes the risk there but presumably things will have to tank pretty badly first???

    Australia is fine cause Wayne Swan said so. I feel very assured by him.

  3. From your piece on the 28th of July:

    “The two speed economy is starting to define the thinking of brokers. Merrill Lynch looks at the reporting season and makes a few fairly obvious observations about where the weaknesses lie. Merrill argues that uncertainty is the theme: in earnings and valuations. They argue if there is no growth in earnings for several years and market settles on a PE of 12, then fair value now would be 4,100. Ouch. Merrill says this is much less than the 5,600 that comes from applying a historical average PE to the current forward consensus estimate. When they use historical average valuations using dividends and price/book the result is 4,800 and 4,600 respectively, giving Merrill a fair value estimate of 4,700. Not much reason to rush to invest in the market”

    Given we’re now at 4100-ish is it reasonable to expect this to be the trading range until something goes pop globally?

  4. That RBS bulletin is a little old (8th June). They might be a little less bullish now.

  5. My view is when RBS and co are giving signals on the market it’s usually because they have the opposite view. Not only that, this new crisis has just started, and let’s see what happens tonight when the US opens. I agree that the Aussie market is more sound than the US P/E wise, but I’ll be watching what happens in China before I’d get back in.

    It’s pretty brave to call this market IMO.