Now that we are in a new bull market, are domestic equities going to rise at double-digit pace for the next five years? After all, that is what happened from 1995 to 2000 and then again from early 2003 to late 2007. The answer is no. The logic behind this statement is derived from understanding what part of the market cycle we are in and the critical role interest rates will play in determining what unfolds.
This we can be sure of. After nearly five years of a secular bear market, the Australian sharemarket has entered a new secular bull market that will last more than a decade. This fresh bull market should see the All Ordinaries rise about 400 per cent from the bottom in June 2012 until the mid 2020s, but it won't be consistent.
Currently we are in the first stages of this secular bull. This stage takes most market participants by surprise and is characterised by rapid gains inspired by low interest rates. However, this first burst is typically a short stanza that runs out of steam after about 12 to 18 months. At a 27 per cent gain and 273 days since June 4, history tells us we are now about halfway through this first surge. The breakout rally from the secular bear markets of the 1970s and early 1990s lasted about 16 months and clocked up 60 per cent gains.
Once the first leg is over, a period of consolidation sets in.
Unfortunately, consolidation is more often than not a euphemism for a market correction where stock prices retrace up to 30 per cent of their first stage gains. During the consolidation interest rates rise to more normal levels from cyclical lows. Don't be surprised if the US market finds this consolidation period a long and drawn-out affair simply because monetary policy is so loose.
Two weeks ago the Dow Jones Industrial Index fell 200 points simply at a hint by the Federal Reserve that money printing would have to stop at some stage.
Once interest rates are back to customary levels the market can get into the guts of the new secular bull market, making double-digit gains over four or five years.
How about Australian interest rates? On Tuesday the Reserve Bank of Australia will meet and decide if rates should stay steady at 3 per cent or move 25 basis points lower. RBA governor Glenn Stevens and his board will have spotted green shoots in the economy, especially in housing finance, and be content to sit and wait. After all, Stevens will be acutely aware that housing is typically the first responder to lower interest rates, followed by retail spending, before eventually companies stop cutting costs and start spending on capital to meet the increase in end demand. Stevens will be confident to cut again if this cycle falters.
The strong possibility of interest rates staying around 3 per cent for the course of 2013 should not concern sharemarket investors. History tells us that equities can easily track higher in this environment.
So what will trigger a jump in interest rates in late 2013 or early 2014? On most occasions the catalyst for tighter monetary policy is sheeted home to inflation or a spike in economic growth. Of these two culprits the most likely to appear is a pick-up in economic growth. Most bulls will say this will provide the platform for the next leg of the bull market.
To the contrary, a spurt of economic growth after a recession or a lull is bad for equity markets. Sure, there will be sectors that thrive, such as resources, but the rest of the market will find the going tough. How can this be given a strong economy is the number one driver of higher earnings?
The answer lies in interest rates. In periods of low interest rates, company price to earnings (PE) multiples expand and in periods of rising interest rates PEs will contract.
Let's take a company that is earning $100 million of profit and forecast to grow at 10 per cent. With interest rates sitting at around 3 per cent, the market is happy to place an 18 PE on the stock. That means the equity value of the company is $1.8 billion.
If the RBA decides the economy is travelling strongly and decides to move interest rates from 3 per cent to 5 per cent then the investors will want to pay a lower multiple for the stock of, say, 14 times.
Even if the company's earnings grow at 15 per cent because of the improving business environment, the share price will head south. The equation reads $115 million profit at 14 times delivers a market value of just under $1.6 billion.
This is only an 11 per cent drop in the company's valuation. Hardly unnerving! What we are talking about here is not a 1987 or 2008 style crash but the first correction that may last 12 to 18 months in a new secular bull market.
The correction will leave many investors dispirited given they believed they were buying into a new bull market. The message is: be careful in 2014, but don't get disheartened because the bull is back in charge.