Back to value on the ASX

Markets are down about 5.1% so far in this rout (from a September 2 peak to today, September 24), a fall that brings Aussie equities to their lowest point since March. Of more concern is that the drop basically wipes out nearly all the price gains for the market this year. Now when you consider that most major global equity indexes aren’t following suit, it’s a strange move. As best as I can tell this underperformance is driven by a confluence of factors that have little to do with Australia’s actual economic performance or the earnings performance of our corporates.

Aussie equities are falling because the US economy is strong

Much of the downward trajectory can be attributed to two key factors: the surge in the US dollar and concerns over a Chinese slowdown (and specifically its impact on the iron ore price). Arguably the former is more important. That’s not to say the iron ore price and China have been irrelevant - they are important. Yet the iron ore price slump and concerns over China have been in place for some time - even as the All Ords hit its highest point since the GFC in early September. Recall the great puzzlement over the fact that the Australian dollar had held its value in spite of the iron ore price slump. This is true, it did, and it still held up even as the iron price fell further. To my mind, the fall in the iron ore price is certainly not helping to buoy the currency, but neither is it playing the major role in its recent fall.

Chart 1: AUD and All Ords fall together

That major reason for the currency’s drop is the spike in the US dollar that has occurred. Sure, the rally had been in place since about July, but it took on a new impetus in August, breaking out of its range. It then accelerated further from early September, posting its largest spike in about a year. Naturally, we know why the USD is surging: the economy is very strong, and the market expects the US Federal Reserve to tighten rates - perhaps as early as next year. 

Now take a look at chart 1 above.  After a period of relative stability, both the AUD and the ASX 200 appear to have capitulated suddenly in early September as well. Why would a USD spike (and a consequent AUD depreciation) lead to a fall on our stock market? Because the currency’s demise spooks foreign investors – they flee the market in an attempt to stave off currency losses. In that regard you’ll note that the stronger-than-expected Chinese manufacturing data we saw on Tuesday, September 23 had no lasting impact on either our currency or Aussie equities.  

The pull back is a boon for investors

Whatever the case, and I’m sure that there are those who would disagree with my view above, it’s already apparent that value has returned to the market. I don’t think there should be any doubt that it provides domestic investors with a great opportunity to make a portfolio allocation out of cash and into stocks.

I am of course aware of what we all read and hear in the press – it’s very negative. Fortunately it’s also very wrong. The data flow provides a much better guide than the gut feel of commentators and the data is unequivocal.

1. The Australian economy is doing very well indeed. Growth is above trend, jobs growth is strong and this will support company earnings - it already is.
2. We shouldn’t be worried by a slowdown in China. The economy is still growing at a very strong rate and there is very little chance of a property-induced credit crunch. 
3. The USD won’t rise in perpetuity and it is lifting for all the right reasons: US economic growth is very strong.

Chart 2: The ASX200 is cheap!

The best way to view this 5.1% fall, then, is as an opportunity. Aussie equities have cheapened considerably. The 12 month trailing price-earnings ratio has dropped to 15.5 from 16.6 - which is about average. On current earnings estimates that brings the year-end price-earnings ratio to 15, which is nowhere near rich territory - the peak over the last few years was closer to 19! More importantly, and on next year’s earnings, the P/E ratio falls down to 13.8 which is well below (see chart 2 above). To consider how cheap that actually is, you have to adjust that P/E ratio to the lowest interest rates on record. A P/E ratio of 13.8 isn’t just cheap in a world of ultra-low rates - it’s extremely cheap.

Now while the sell-off has been broad-based across sectors - miners and banks leading - there are some differences in terms of value.

Chart 3: Discount from normal valuation

Just on the numbers, consumer discretionary, health, materials, utilities and IT are currently at substantial discounts to their usual valuations and as a result look to be the cheapest. Having said that, these metrics make no consideration of the investment backdrop. Sometimes stocks are cheap for a reason - we need to be careful. At other times a strong argument can be made as to why a stock or sector should be trading at a sometimes substantial premium. I would put financials (and in particular our banks) into that basket and they’re about 40% or so of the total market capitalisation. Consider that their growth prospects are excellent and they pay a high dividend - the credit cycle has turned and is strengthening. What’s not to like? On that basis I think our banks offer value at these levels.

I’m otherwise cautious on resource stocks. I’m still of the view that strong Chinese growth rates will support actual production – that the supply glut has been overestimated and that revenues will be strong. Let’s face it though, they’re not market darlings, and the idea that China is in trouble is getting a lot of airtime. They’re a long-term buy but in the short term they carry a lot of risk.

Banks and miners add up to 50% of the market just there. More broadly, this pullback has injected some value back into the market and it’s a good time to go shopping, top up or recalibrate your portfolio. There could of course be a bit more downside, and it wouldn’t take much for this to turn into a full-blown correction. Just note, however, that a full-blown correction would be unusual in the absence of a broader downward move in international equities.