Don't Go!

By most definitions, we are in another worldwide sharemarket boom. Since the bottom of the crushing post-millennium bear market three years ago, the main American share indexes have gained between 50 and 100 per cent; the European and Japanese markets, despite the slackness of their underlying economic performances, have racked up similar gains in the past two years; and the broad Australian market has soared more than 60 per cent since its early 2003-cycle low and is now setting record highs almost every day. What should we think about all this? Is it time to run for cover, and, if so, into which other asset bunker should we dive?

Rather than getting crusty in my old age, I think I must be going soft in the head because I still cannot see compelling or urgent reasons, fundamental or technical, for any of us to part company with the bulls. Moreover, I really cannot fathom the thinking behind the growing Australian adviser consensus to shift to international from local equities.

The fundamental underpinnings of the global bull run show that this is not another mad New Age phenomenon that depends on investors being sucked into improbable paradigms. It has very little to do with miraculous new technologies, or with reckless damn-the-torpedoes portfolio strategies. Nor does the underlying rising confidence in shares seem to be due to a fugitive displacement of funds that would otherwise be parked in the property, fixed interest or commodities markets. On the contrary. We have asset prices rising across the board as well as across the globe. How can this be?

In short, it is because the world economy continues to grow at a healthy nominal rate of about 8 per cent a year '” an average of, say, 5 per cent real and 3 per cent inflation '” that will double global GDP within 10 years. This is being accomplished on the back of an irreversible combination of population growth in the developing economies, free trade and capital flows, strong productivity gains and abundantliquidity. And, while these powerful factors remain in play '” despite terrorism, energy-price shocks and falling unemployment '” inflation will stay reassuringly low, and so will interest rates. The old business cycle has lost its sting and we can at last afford to take a long view as strategic investors.

What that long view should show us, if we pay enough attention, is that the combination of strong steady growth and stable low inflation is extraordinarily good for profits. If nothing transforms those underlying conditions, the profit outcomes, in terms of their quantity and quality, will continue to exceed expectations, and it is that sequence of favourable surprises that keeps a real bull market like this one going. As steady sales growth flows strongly to profits through efficient balance sheets, capital expenditures can rise at least as fast as dividends without crimping future growth. That maintains earnings expectations while simultaneously boosting the income flow to shareholders, despite the natural rise it causes in share prices.

What is noteworthy about this bull market '” what really sets it apart from previous speculative frenzies '” is that dividend yields and price/earnings ratios have remained remarkably steady, and at far from speculative levels, as profit growth and dividend growth have kept pace with the rise in share prices. I can see no credible evidence that this is about to change. There are no hints of wage explosions or of leftward political lurches. There are no dramatic changes in tax policy in the wings. And, while global interest-rate policies may be tightening slowly to keep a careful lid on an inflation outbreak, the growing integration of so many low-cost newly developing economies into the world's trade channels is having a far more powerful effect than official interest rates in keeping inflation down everywhere.

All of this applies to the Australian sharemarket, too. The broad All Ordinaries index has risen by about 23 per cent in the past year '” roughly on a par with the recovering European markets, whose 12-month gains range from 21 per cent in Britain to 26 per cent in Germany. It has outstripped the 13 per cent rise in the American large-capitalisation S&P 500 index and has even beaten the US technology sector, whose NASDAQ index has managed an advance of only 17 per cent. It has comfortably beaten the Japanese Nikkei 225 index's paltry 8 per cent gain has been just pipped by the Hong Kong and Canadian broad indexes, which gained nearly 25 per cent over the year. Why, then, are so many Australian investment professionals advocating a re-weighting into foreign shares?

Not, it seems, because they are expecting foreign economies to outperform Australia's. The forecasts for OECD real GDP growth in 2006 is little higher than this year's expected 2.6 per cent, compared with Australia's predicted 3.4 per cent. America's growth should be little better than 3 per cent, Europe's will be lucky to exceed 2 per cent and Japan's growth is likely to trail Europe's. Australia, on the other hand, will be boosted by tax cuts, a rural recovery, a pickup in consumer confidence as employment growth links up with a stabilising property market, and thepersistently powerful tractor of our flourishing terms of trade with Asia.

Nor, it seems, are the bulls of foreign shares especially optimistic about international profit growth or dividend growth, or even about interest-rate developments, relative to Australia. The strong momentum of the present profit-reporting season suggests that earnings growth is likely to exceed 20 per cent again next year, a rate that few other markets will be able to beat. And if that growth in profits is achieved, it will keep our price-to-earnings valuations and dividend yields comfortably within historic ranges '” the market's price will continue to climb without becoming "expensive" on the traditional valuations. This is particularly the case in the resources sector where Australia's comparative advantage so clearly lies '” our "old economy" structure is a huge positive in a conventional sharemarket boom like this one. So I ask again, why are we now being exhorted to change horses if the alternative mounts don't look any fitter or faster than ours?

The answer comes down to one peculiar local superstition: that tall poppies are doomed to be decapitated. The Australian index might look relatively cheap on its fundamentals, but it's at a record high, whereas the American and Hongkong markets are still 17 per cent below their peaks, the broad London index still lags its own record by 24 per cent, and the German market, despite doubling from its 2003 low point, still has another 38 per cent to catch up. Even more alluringly '” for those who believe in such statistical magic '” the NASDAQ index can still rise 56 per cent, and the poor devastated Japanese Nikkei index by no less than 69 per cent, before exposing their delicate flowerheads to the grim reaper's scythe.

A lemming would never perish if he stopped looking over his shoulder. This sort of wishful investment "thinking" deserves to be challenged by everybody who believes that markets ultimately look to the future, not the past. Stay long, and stay here where you belong '” in the sharemarket of the lucky country.