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Key points
- The evidence is continuing to accumulate that shares have embarked on a cyclical recovery.
- Further gains are likely: shares are cheap and the economic recovery will lead to an improvement in the profit outlook. There are still plenty of funds sitting on the sidelines and there is still a lot of healthy scepticism about the rally which is normally a good sign.
- Past cyclical upswings have seen Australian shares rise an average of 132% over an average of four years.
Bottoming action
From a technical perspective, share markets appear to have built a good base over the past nine months.
Source: Bloomberg, AMP Capital Investors
Markets fell sharply into November last year on very heavy volumes and in the midst of complete panic. While the bulls attempted a recovery into early January, it lacked any conviction. With economic data still being poor, the bears were able to gain the upper hand again into March.
However, the fall into March did not generate any follow through and when economic data failed to deliver on the feared depression shares took off. The churning up and down in a wide range late last year and early this year is indicative of past bottoms in share bear markets including that in 2002-2003 in the US. Since then, shares have started to trace out a pattern of higher highs and higher lows. Additionally, in a bear market, shares struggle to break above their trailing 200 day moving average, so the recent decisive break above 200 day moving averages is a positive sign.
A typical cyclical bull market
The typical short-term investment cycle lasts around three to five years and looks similar to the chart below.
Source: AMP Capital Investors
During an economic slump, government bonds are attractive and eventually monetary and fiscal stimulus set the scene for the next economic recovery. Shares normally anticipate this and start to increase about six months before the economy bottoms. This is the period in the cycle where shares climb the classic ’wall of worry’ as there is still uncertainty about whether there will be an economic recovery. This eventually gives way to a ’sweet spot’ in the cycle where growth and profi t expectations are recovering but inflation and interest rates are still low and stocks are cheap. This is usually a time when investors are still worried, but it is often the most prosperous time for shares. After a few years or so, inflation builds and interest rates rise to onerous levels, setting the scene for the start of the next cyclical downswing in shares and the economy.
Currently, it seems that shares are entering the classic ’sweet spot’ as leading economic indicators are improving virtually everywhere. However, because there is excess capacity worldwide, inflationary pressures will remain low.
The next chart shows average inflation in the US, Japan and Europe versus a measure of capacity utilisation averaged across all three regions. Whenever capacity utilisation is below normal – zero on the right hand side axis – infl ation has fallen. In other words, with economic activity having fallen so far worldwide there is plenty of scope for a recovery before inflationary pressures kick in.
Source: Thomson Financial, AMP Capital Investors
On top of this, while shares are as cheap as they were back in March, they are not expensive either. Forward price to earnings multiples are around 15 times in the US and Australia which is in line with their long-term averages. However, in Australia, if trend earnings are used rather than the depressed level of consensus earnings then on the basis of a 15 times price-to-earnings multiple, fair value for the market is currently around 4600.
Finally, the earnings revision cycle is turning up in most countries as evident in the next chart. Typically, during an economic downturn companies start to factor in the worst and slash costs to compensate. When revenues don’t fall as much as feared, profits start to surprise on the upside. This is now what appears to be happening in the US with 75% of June quarter results surprising on the upside (compared to a norm of about 59%). The same is likely to occur in Australia over the coming month.
Source: Thomson Financial, AMP Capital Investors
There is no doubt that the road ahead will be rough. However, the combination of improving economic indicators, an improving outlook for profits, reasonable valuations, low inflation and low interest rates is very positive for shares and suggests we are entering the ‘sweet spot’ in the investment cycle. With cash weightings still well above normal levels, this suggests there is plenty of scope for funds to come into the market and push shares higher.
How long do cyclical bull markets last?
If we have commenced a cyclical upswing, how long could it last? The next table shows the history of cyclical bull market in Australian shares. I have defined a cyclical bull market as a rising trend in shares that ends when shares have a bear market (defined as a 20% or greater fall that takes more than 12 months to be reversed).
Source: Bloomberg, AMP Capital Investors
The bad news is that on average it has taken around three and a half years to regain the prior high point once a bull market starts. The good news though is that a typical cyclical bull market has seen shares rise by 150% (the average since 1894) or by 132% if averaged from 1950. And since 1950, the typical cyclical bull markets lasted four years. The high level of household debt and the need to reverse government stimulus suggests a more constrained and shorter cyclical upswing this time around. However, against this, the severity of the bear market and historically easy monetary conditions still suggest plenty of upside over the coming years.
Conclusion
The longer term picture is likely to remain difficult in the US, shares have likely embarked on a new cyclical bull market that has further to go. Shares are inexpensive and the economic recovery will lead to an improvement in the profit outlook. There are still funds sitting on the sidelines and healthy levels of scepticism about the rally which is a good sign. There is also a good chance that the US S&P 500 index will gain appproximately 25% from current levels over the next 12 months. In this context, a rise to 5000 for the Australian share market by year-end is conceivable. The average cyclical bull market in Australian shares in the post-war period has lasted four years and seen a gain of 132%.
Going forward, investors will need to focus on a new set of signposts as to when the rally will peak. These are likely to include measures of capacity utilisation and inflation and the speed with which government stimulus is removed.
Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors
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