|Summary: The 5,000 point barrier has been a key resistance level for the Australian sharemarket, and today it fell back through it over concerns about China's growth and after a weak offshore lead. But solid earnings growth forecasts and ongoing demand for equities should see it push higher over the medium term.|
|Key take-out: While the market may gain overall, whether investors make any money or not will depend largely on taking the right sectoral view. Not all sectors will outperform.|
|Key beneficiaries: General investors. Category: Growth.|
Can we lift off from 5,000?
It was a hard slog, but the All Ordinaries Index finally managed to break through the 5,000 barrier in early February, having spent most of the previous two years below. Since then, however, there’s been nothing.
Meanwhile US stocks are up 5%, and even some of the large European bourses are up 3% with the all the troubles they have. Unfortunately though, I think we’re all more than aware of the fact that the Aussie market in reality has done little since 2009 and the post GFC recovery (3% over four years).
The 5000 points level has proven to be the magic mark time and again for the All Ords and a very powerful line of resistance – really you’ve got to go back to 2008 to have seen our market sustained above that level. Today, for example, the All Ords fell around 49 points, or 0.9% – following a drop on Wall Street on Friday and concerns over Chinese economic growth – closing the day back under 5,000 at 4,966.8.
The big question for all of us is, can we lift off from here – is it different this time?
Well, let’s look at what we know. The metric shows broadly that:
Our market is not expensive – but it’s not cheap: The market is fully priced by the looks, with the ASX 200 posting a trailing price to earnings ratio of about 16.96, which is a bit above the average since 2000 of 15.5. You can see from the chart that the PE ratio of the ASX 200 doesn’t indicate we’re in expensive territory. We’re about where we usually are, although maybe at the top end of that. No extreme values though. Now, for the market to be regarded as a little more average, you would, in effect need to see earnings growth of around 8% over the next year. If we got that, the PE would be around 15.5, which is average. No dramas.
There are two associated questions investors need to ask themselves then. Can earnings accelerate by roughly 8% over the next year? And how much, if any, of a premium are investors willing to pay?
Dealing with the former first – 8% earnings growth is definitely not a stretch. The average over the last four or five years is a little below that admittedly, at around 6% for our large stocks. But 8% is a ball park figure, and that 6% occurred during a lot of doom and gloom. The world is a little different from then, the outlook is better globally given the enormous stimulus in place and global growth is picking up. Domestic growth is expected to remain robust. All the macro forces are in play, and I guess another way of looking at it is that there is certainly no reason to expect weak earnings growth. This is probably why the consensus expectation for earnings growth over the next two years is pretty much around the 8-10% mark.
So then, what about the premium/discount issue? Well, every metric I look at tells me that investors are taking on more risk. They are normalising their portfolios, aided by the lowest interest rates on record. This is forcing investors out of cash and low-yielding bonds and into riskier assets – we know the drill here. In the professional market, the VIX (Volatility) index is low, people are no longer worried by a US double-dip or the implosion of the euro zone – Spanish and Italian bond yields are falling.
In that environment I would suggest that it’s highly likely investors are prepared to pay a premium for stocks. With all that going on, you would have to be worried by some significant disaster to stay in cash or bonds. I mean, where else are you going to get a decent return? Fact is, you can see that already. Investors are already telling us they are prepared to pay a premium for the right stocks such as health companies and telcos etc, whose valuations, it could be argued, are stretched. What we don’t know is how much of a premium people will pay.
For my purposes today, we don’t need to know though. We don’t need to bog ourselves down with an exact quantitative estimate – it will suffice just to know that a premium is reasonable. So where does that leave us?
- A market which on past earnings is fully priced and at the top end of recent averages.
- A market that, based on modest forecast earnings growth of 8% or so, is much closer to average.
- The knowledge that investors are willing and will continue to be willing to pay a premium given the lack of investment alternatives.
Armed with this knowledge, I know the market certainly can push higher. Even if we take the current PE (almost 17) as an indicator of what premium the market will pay, that implies a price gain of 8-10%, based on current earnings forecasts of 8-10%. That is, to maintain the current price to earnings ratio, which the market seems quite happy with. So 5,400 or 5,500 by year-end certainly isn’t a ridiculous forecast, and based on current earnings momentum even that wouldn’t represent an overvalued market. No one could argue it was rich or expensive.
So, can Aussie stocks lift off from 5,000? Absolutely they can! Whether they will or not is a very different question though.
The problem we face in Australia is this unrelenting pessimism I’ve written about before, and nowhere is this more evident than in surveys on business confidence. You can see from chart 2 there has really been no improvement in business confidence since the sharemarket rally started last year and since interest rates were cut.
I suspect a big part of this reflects the fact that that the heads of some of our largest companies on the ASX themselves talk down Australia’s and their own prospects. Why? Rent seeking. To influence public policy, get rates lower and try to force some action on the exchange rate. The issue of the Australian dollar looms large here and there is this erroneous belief, not backed by evidence, that a strong dollar is bad for Australia and our stockmarket. Chart 3 shows in fact the reverse is true. A strong Australian dollar is associated with a buoyant sharemarket and rising commodity prices – especially from the rally of mid-last year.
Related to this is the fact that our miners, which are roughly 20% of the market, are not in fashion. The consensus is consumed with talk of a commodities supply surge and weak Chinese growth, but neither is happening. This might make our miners cheap on a longer-term view, but in the short term this misperception is a significant headwind.
Getting your sectoral view right is more important than ever this year. While I might argue that the ASX can lift off from 5000, whether investors make any money from that or not will depend largely on getting their sectoral view right. We saw broad-based gains last year, but I’m not sure that is going to be the case for the rest of this year.
On a three to five-year view I remain very confident that, the way things look now, our market still retains value and will push higher. I can’t say the same things over the next six months with those domestic headwinds though. And that’s not to forget the significant global headwinds to sentiment, but I’ll talk more about that over the next couple of weeks.