ASX faces tough slog ahead

The latest earnings reporting season for Australian listed companies is almost past, and once again, a major theme from the latest earnings reporting season is that  profits were “not as bad as we thought they would be”. In the main, corporate Australia has largely met investors’ (already beaten down) earnings expectations.

Despite such relief, however, there are several reasons why the Australian equity market still likely faces a tough road ahead.

For starters, earnings have held up despite general weakness in top-line sales growth – in other words, many companies have achieved their profit targets only through ruthless cost cutting.   While this can support earnings in the short-term, it is not a sustainable way to boost investor returns.

Secondly, earnings growth expectations remain under downward pressure.  After lifting through 2013, 12-month forward earnings for the market have broadly flattened out over the past six months reflecting downgrades to the expected level of earnings in FY’15.  According to consensus analyst expectations, earnings in FY’15 and FY’16 are currently forecast to grow 5.8% and 8.4% respectively, after growth of around 7% estimated for FY’14.  If these expectations hold up, it would imply only 6% growth in forward earnings by mid-2015.

But against the backdrop of a still high $A, cautious consumer spending and declining commodity prices, further earnings downgrades still seem more likely than upgrades.

A further concern is that valuations are getting stretched, with unsustainably low interest rates acting as a support. At almost 15 times forward earnings, the market’s forward PE ratio has pushed above its 10-year average of 13.6.  Indeed, the forward PE ratio has only held above 15 for 10 per cent of the weekly readings since 2003.

Of course, the decline in 10-year bond yields through this year – from 4.25% p.a. to around 3.5% p.a. – has allowed the market’s relative valuation to inch slightly into cheap territory.  The gap between the market’s forward earnings yield and 10-yr government bond yields has lifted to 3.4% p.a., for example, compared with a 10-year average of only 2.6% p.a..  But with both United States Federal Reserve and the Reserve Bank of Australia both likely to raise official interest rates by mid-2015, bond yields are likely to rise, pressuring market valuations.

Muted Gains Likely Ahead

If both earnings expectations and the market’s PE valuation hold up in the coming year, the S&P/ASX 200 index would be expected to rise by 6 per cent (in line with the prospective growth in forward earnings), reaching close to 6000 by mid-2015.  More likely, however, we’re likely to see further modest downgrades to earnings expectations, and some downward pressure on the elevated PE ratio as interest rates eventually push up toward more normal levels. As such, we’re likely facing an environment where the market’s upward momentum is a slow grind. 

BetaShares YMAX Fund

Investors that accept that only muted share market gains are likely ahead might consider strategies that seek to enhance returns beyond capital growth – such as through a “buy write” or “covered call” strategy.  By selling (or “writing”) call options against shares – i.e. giving the right for other investors to buy your shares in the future should their prices reach a certain level – investors can gain option income in exchange for foregoing some possible capital gains upside if the market does indeed rally strongly.

Of course, dabbling in options can be complicated for the average investor.  To that end, BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) (ASX Code: YMAX) might be of interest – as it effectively implements such a strategy on the investor’s behalf.

YMAX is an exchange traded product that can be bought and sold on the Australian Securities Exchange as easily as a company share.  The Fund passively hold stocks represented within the S&P/ASX 20 index, meaning they are among the 20 largest, most liquid, and actively traded stocks on the market.

Along with the stock holdings, the Fund also sells exchange-traded call options on up to 100 per cent of the securities in the share portfolio.  By writing call options, the Fund will receive option premiums which are expected to provide an additional source of income for the Fund and a partial hedge against a decline in the value of the share portfolio. Against this, the Fund’s strategy implies some sacrifice of upside capital gains should the market rise especially quickly.

In the year ending July 2014, for example, the Fund produced a 13.3% return, underperforming the S&P/ASX 20’s return of 16.3%. Yet the Fund’s gross distribution yield over the past year was 11%.