Where's the market going - and will it be banks or miners that drive it on? David Potts investigates.
With so little on offer from a bank or bond, it's no wonder the sharemarket is rising. The surprise is where it's occurring. Or rather, not occurring.
BHP Billiton, normally a bellwether capturing the Australian economy in one stock, has been falling for some time. Technically the big resource stocks are perilously close to being in a bear market, which is a 20 per cent fall from a peak. The rout in gold stocks has been almost twice as bad as the price of bullion eases and production costs rise.
Without the drag from BHP and other resources stocks, this would be a bull market. Experts are tipping an All Ordinaries Index at 5500 by the end of the year, which would add another 10 per cent to the 23 per cent gain from its lowest point last year.
The strength is coming from banks paying dividends to die for and stocks sensitive to household demand such as the retailers, which by rights should be struggling. In fact, 80 per cent of the sharemarket's gain last year came from the top-10 stocks, Mark Thomas, chief executive of Van Eyk, says.
A market milestone has been the Commonwealth Bank surpassing BHP Billiton as Australia's biggest stock by market value. Yet BHP's profits are nearly double CBA's. "Traditionally, a strong Australian dollar to the US dollar has been associated with stronger share prices for the miners," say brokers RBS. That might seem odd, but a strong dollar means high commodity prices. While the price of iron ore has slid from its peak, it has bounced off the bottom and seems to be holding up at a very profitable $130 a tonne or so.
Despite high commodity prices and record investment, resource stocks have been written down so far that brokers are starting to recommend them again. But there's nothing cheap about the banks' share prices considering the outlook for lending, which is their main game. Overall, the market is considered to be fair value based on the most commonly used measure of a share's price-earnings (P/E) ratio.
That makes it neither a screaming buy nor a candidate for serious correction.
Strangely enough, Wall Street, which has rallied far more than the Australian market since the GFC, is generally considered to be slightly undervalued. But in Australia the P's of P/E ratio have risen faster than the E's.
The reverse holds in the US thanks to the boost to multinationals' profits from its weak dollar, as well as corporate cost-cutting and falling real wages. This would suggest the Australian market has run ahead of itself, a result of the influx of foreign money looking for something better than the near-zero yield on bank deposits or bonds in the US, most of Europe, and Japan.
"The market always runs in front of earnings," says chief investment officer of Platypus Asset Management, Don Williams, though he warns banks have become expensive. But their appeal is undeniable. On dividends alone, even the Commonwealth, trading around a record price, is generating a yield of more than 7.5 per cent from its dividends after counting shareholders' 30 per cent tax break from franking.
The returns on its rivals are even higher. The problem is that the banks have a lot of capital but are doing little lending because of the weakness in the non-mining economy. This will keep a lid on their profit growth, which in turn will hold back their share prices and, in a future bad-hair day in the market, might undermine them.
The higher the banks' share prices go the lower the yield because you're paying more for the dividends, and the riskier they become without a surge in profit-generating borrowing by business and households around the corner. This might seem fanciful, though the market is looking six months to 12 months ahead. Official economic forecasts are for a pick-up in growth next year mainly based on a turnaround in housing, which in turn will depend on how unemployment pans out.
If stronger economic growth doesn't arrive on time, the Reserve Bank has left no doubt it will cut rates again, which if nothing else would make bank dividends look even more attractive. And the less the banks lend, the less capital they need and the more they can pay in dividends.
While it seems the banks can't lose, having a subdued business while pumping out ever-higher dividends is unsustainable. Plus, they are compelled to hold a certain amount of capital as a safety buffer.
They're also trading on a higher P/E ratio than is normal for them, or seems warranted in a subdued climate for lending.
Then again, the central banks of the US, Europe and Japan are pumping money into their economies, creating spare cash looking for the best return for the least risk. This puts high-dividend-paying Australian stocks in the front of the queue.
But just as bank share prices have been distorted by a global cash dash for yield, the same goes for resources stocks in the other direction. They've been marked down due to slower growth in China, a blowout in big project costs and their poor dividend yields. It could also simply be market cycles.
"Every five years for the past 30 years they've had a low and it's due now," Dale Gilham, chief analyst of Wealth Within, says. In this market, yield comes before growth, but a growing number of analysts say resources shares have been marked down too far. The trouble is "they're cheap, but could get cheaper", Angus Geddes, chief executive of Fat Prophets, says.
But resource giants BHP and Rio Tinto haven't endeared themselves to their own shareholders, either. In a yield-seeking world, neither pays a handsome dividend. Both have also committed huge amounts to big projects even though they are the first to admit commodity prices have peaked.
Under new chief executive Andrew Mackenzie, BHP will lift its freeze on approving new projects from July 1. The market has been spooked by the huge blowout in the cost of big resource schemes, especially liquefied natural gas projects such as Woodside's shelved onshore processing plant for its Browse joint venture.
"[BHP is] making the right noises about a focus on returns to shareholders and capital management. But then you wonder what the previous management was doing," Matt Williams, head of equities at fund manager Perpetual, says. BHP and Rio are trading at the same value they were when the iron-ore price was below $100. Today it's about $135.
Commodity prices have been buoyed by central bank money printing, especially by the US Federal Reserve. Just as it has spilt over into other sharemarkets such as ours, quantitative easing has also devalued the US dollar, so anything expressed in it, which is most commodity prices, becomes correspondingly dearer.
That these have peaked is not in doubt. The question is whether the additional supply coming on stream from developing countries will be met by higher demand as the global economy recovers. China, by far our biggest buyer of iron ore and coal, has deliberately slowed its economic growth rate to about 8 per cent. But if you take a longer perspective, CommSec chief economist Craig James says, resource stocks are going for a bargain.
"There's now a major focus on costs rather than new expansions," he says. "And China is undergoing the biggest industrialisation the world has ever seen. If you invest more for the medium term of three to five years, bargain hunting will be rewarded."
He has $1.5 million of shares stacked into his DIY super fund and says the secret to sharemarket investing is to never panic.
After taking a $330,000 superannuation lump sum from Telstra 13 years ago, retired telegram boy-turned-supervising technician Michael Burke sought out 10 different advisers. "I'm a technician, so I'm a bit pedantic about checking," Burke, 67, says.
He then decided he was better off investing it himself. "They only knew as much as I did and were more interested in how much money they were going to make from me."
About 20 per cent of his fund, which dipped below $1 million in the global financial crisis, is in the banks and almost one-third is in resources stocks. He picked up CBA shares, which lately have traded as high as $70.95, for $14 in the GFC.
"My investment tip is: don't panic!"
Although Michael has been buying more shares than he is selling, he is going to flip this around.
He is banking on a correction in the sharemarket so he can pick up stocks more cheaply. "I'm going to start selling to build a slush fund for the next correction," he says.
And CBA is in the firing line. "Its price is unbelievable. I'll lighten up a bit."
“We’re heavily into banks, Telstra and higher yield small to medium stocks.”
“Resources stocks are cheap but I don’t think they’re a 2013 story – more 2014.”
“All that cash on the sidelines is starting to find a home.”
The fund manager
“The market feels very strange and unreal. If liquidity tightens all bets are off .”
“There will be a few bumps along the way with a high risk of a short term correction.”
“The banks are so solid it’s not funny. It’s not just yield – there’s an upside for price too.”
Interested in banking stocks? Our Hot Stocks experts run the rule over Bank of Queensland. At theage.com.au/money.