About time bull market took a breather

AS FIXED-interest rates stayed low in the second half of last year the question for investors to answer was whether higher yields on offer in the sharemarket should be locked in.

AS FIXED-interest rates stayed low in the second half of last year the question for investors to answer was whether higher yields on offer in the sharemarket should be locked in.

There were easy pickings at that time: quality companies whose shares could be bought on a dividend yield that thrashed fixed-interest alternatives.

Share buying here and overseas in recent months hasn't totally undermined the yield argument, but the equities rally has made it less compelling.

The Commonwealth 10-year bond yield fell from about 6.7 per cent in June 2008 as the global crisis was heading into its cathartic peak to 2.8 per cent in early June last year. The S&P/ASX 200 Index was sitting just under 4000 points when the bond rate bottomed. It is now sitting just below 5000 points, 25 per cent higher.

The gain here since mid-December has been about 8 per cent, and shares have rallied around the world in what has been described as a "risk off" rally (a rally that occurs when investors decide they do not need such a large risk premium to move their dough into shares) or a "rotational" rally (a "weight of money" boost that comes as demand boosted by bond sales chases an unchanged supply of shares).

I am still long-term bullish on shares that are backed by solid business franchises, strong management and conservative balance sheets. It's in my DNA, and that of many other investors. On a total shareholder return measure that combines dividends and capital appreciation, they are essential components of any balanced investment portfolio.

For investors who saw the rally coming, however, the 2012-13 rally has reached a point where it is now offering profit-taking opportunities, and is once again presenting risk of capital loss, if Europe's problems flare again as they may well do later this year for example, or, a bit later, if economic recovery finally forces northern hemisphere interest rates higher again.

One of the simple definitions of a bull market is that it begins after key indices go up by 20 per cent. On that measure the bull is back in the paddock, and AMP capital strategist Shane Oliver observed this week that if it's real, it could have a way to run. Since World War II a typical bull market here has pushed the key index up by 126 per cent, over a period of almost four years.

As Oliver and others, including Evans and Partners strategist Michael Hawkins also observe, however, valuations are becoming stretched. Hawkins says that excluding the banks, industrial shares on the ASX have moved from a price-to-earnings ratio of 12.8 times expected earnings in the middle of 2011 to 16.2 times now. The multiple has risen that sharply because earnings growth has been too slow to keep pace with share price increases.

A high Australian dollar, subdued consumer demand, soft jobs market and investment inertia are behind economic lethargy that is sapping earnings, something underlined on Friday by the Reserve Bank's prediction that economic growth this year would be just 2.5 per cent. Last May it was predicting 3.25 per cent.

Oliver noted this week that bull markets typically occur in three stages. The first sees shares rise as dividend yields become too good to ignore, and as hopes of an earnings recovery emerge. The second stage sees less aggressive price earnings multiple expansion, but more share price gains as companies deliver earnings growth. In the third, toxic phase, investors ignore valuation warnings and push prices to unsustainable highs, setting up the conditions for a selloff and the re-emergence of the bear.

Earnings growth will come. Economies don't stay soft forever. The baton pass to the second phase of earnings growth is due, however, and in its absence, the share prices of quality companies are becoming challenging.

The earnings yield on non-bank industrial shares has fallen from 7.8 per cent in mid-2008 to 6.1 per cent as prices have risen. That still comfortably beats the 10-year Commonwealth bond yield, which has risen since the middle of last year from 2.8 per cent to about 3.5 per cent. The ASX 200 index's dividend yield of 4.24 per cent offers less headroom, however, and Hawkins says quality shares are now in profit-taking territory.

Shares in Wesfarmers, for example, are up almost 5 per cent this year and up 14 per cent since mid-November, and are now trading at 18.5 times expected earnings in 2013-14. Ramsay Health Care shares are up 11 per cent this year, 70 per cent since late February last year, and on a multiple of 19.3 times expected 2013-2014 earnings.

Telstra shares are up almost 6 per cent this year and 45 per cent since March 20 last year, and are trading at 16.5 times expected earnings in 2013-2014. Boral's shares are 15 per cent higher this year and up 71 per cent since mid-2012, and on 17.7 times expected 2013-14 earnings; the group is exposed to the US building and construction recovery that is under way, but at these prices is being backed to double its profit in two years.

There are plenty of other examples. Westfield Group is valued at 15.7 times 2013-14 earnings, Brambles is on 16.6 earnings in the same year, and CSL (an undoubted ornament on the market's mantelshelf) is on 21.3 times earnings. Commonwealth Bank, whose shares are up almost 5 per cent this year and by 37 per cent since early March last year, is on a 2013-14 earnings multiple of 13.6 times - lower than many high-quality industrial shares, but out of line with its peer group: NAB is on a 2013-14 earnings multiple of 10.3 times, Westpac on a multiple of 12.1 times, and ANZ 12.5 times.

These are all companies that sit comfortably in long-term share investment portfolios. You wouldn't want to sell out of them entirely. Until earnings growth accelerates, their share prices are pushing the envelope, however. The whole market could do with a breather: it will be in better condition to move up in the medium term if it gets one.


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