It cannot be pointed out nor repeated often enough, in my view, that ultimately the outlook for equity markets and for investor returns in equities boils down to one critical factor: corporate earnings growth.
Market analysts at CIBC in Canada recently released a research report concluding "about three-quarters of the variability in the TSX’s [Canadian stock market index] performance since 1988 has been due to fluctuating profit expectations". I am unaware of any similar research conducted in Australia, but judging from my own analyses and insights regarding equities in Australia, I think three-quarters (75%) sounds about right.
That still leaves funds flows, geopolitical risks, currency movements, global risk appetite, political elections, natural disasters, market rumours, technical indicators and all other factors that might, on occasion, grab the attention of Mr Market on a day-to-day basis, to explain the remaining 25%.
This is why, for example, I dedicated last week's Weekly Insights to pointing out and explaining that, unless market expectations for earnings growth improve markedly, shares in BHP Billiton ((BHP)) don't look particularly attractive for investors with a medium to longer term horizon, even at these beaten down price levels. In case you missed last week's edition: the world's largest commodities powerhouse is looking towards two consecutive years of negative growth for shareholders, at least according to current consensus estimates. If proven correct, such an outcome hasn't been seen since FY02-03 for the Big Australian.
Note: the Canadian research mentioned above explicitly mentions "profit growth expectations", not "profit growth achieved".
Alas, at face value, the message coming from global profit forecasts is hardly one to boost overall market confidence about the sustainability of the rally currently taking place on global equity markets. From the US to Europe to Emerging Markets, equity strategists all around remain adamant there's more downside to come for global profit expectations as analysts' forecasts remain too high. History shows when profit forecasts are in decline, this usually acts as a dampener on the potential upside for share markets, all else being equal.
In the US, corporate earnings appear to be in a downtrend with suggestions that profit margins may have peaked in the final quarter of 2011. Certainly, the present reporting season hasn't exactly reversed this concern and with economic growth expectations for the US falling below 2% for the quarters ahead, one question that comes to mind is whether corporate profit margins can be sustained amidst such a low pace of domestic growth? The offsetting observation is that US profits are now increasingly made in the faster growing Developing Markets outside the US, Europe and Japan.
It's anyone's guess how these contrasting dynamics are going to play out in the quarters ahead. In the short term, it should be noted that were it not for expectations of more supportive actions undertaken by central bankers in the US, Europe and elsewhere, US equities would likely be experiencing a much tougher environment as even iconic bellwethers such as Apple, McDonalds and now Facebook have failed to inspire, let alone beat market expectations.
Of more importance, however, is that double digit growth now seems to have disappeared from the US corporate landscape. Look beyond the day-to-day noise and, so far, the US Q2 reporting season is shaping up for zero or even negative growth annualised. Investors in US equities will be hoping this negative trend will be reversed in the quarters ahead.
In Canada, the above mentioned CIBC strategists have developed a forward-looking leading indicator for corporate earnings growth in the country. In line with the suggestion put forward by the US reporting season, CIBC's leading indicator is pointing towards an even tougher environment ahead for corporate earnings over the coming twelve months. The best thing investors can hope for, suggests CIBC, is for expectations to improve towards year's end, which would support a good old Christmas rally into the new calendar year.
It's pretty much the same story in Developed Countries where commentary from equity specialists on earnings forecasts mostly seems to end with that same conclusion: analysts' estimates are still too optimistic. Earnings forecasts will have to be cut.
Over in Australia, investors might get the feeling they are caught in a real-life version of Bill Murray's Groundhog Day. Every new financial year starts off with double digit growth expectations but by the time companies are about to report their annual results, these forecasts have transformed into low single digit growth estimates only. Next thing that happens is most companies don't manage to beat those sharply reduced expectations.
Like a good old broken record, it has been this same scenario in Australia for two years in a row now and this year, at the start of the August reporting season, things once again look eerily familiar with consensus forecasts as calculated by FNArena suggesting an average earnings growth pace of around 2.5% for the companies that make up the ASX200. Assuming this number remains in place (in two previous years the actual number fell short of expectations) this would place the ASX on an average market Price-Earnings (PE) ratio of nearly 13.5. Not exactly cheap in the post-2007 context.
As calculations stand right now, the forward-looking average market PE for FY13 sits around 11.7 which suggests the Australian share market is relatively cheap, and thus attractive for investors, but this implied attractiveness is carried by analysts' expectations for nearly 15% growth in the financial year ahead. Were this growth to drop by half in the year ahead, the average PE for the Australian share market would jump to 12.5 about the running average post-2007. This suggests that, unless profit growth starts to surprise in Australia, and to surprise in a significant manner, the share market risks remaining stuck in its trading range for much longer than most investors will be willing to contemplate.
It goes without saying, numerical averages are only a broad measurement and certainly at this point in time they mask the fact there is now a significant valuation-gap between solid industrials that offer yield and a reliable growth outlook and the cyclical stocks in sectors such as mining and energy that have been abandoned and beaten down in a big way. A large chunk of next year's profit expectations -both in Australia as well as internationally- is based upon projections of strong growth for stocks in these beaten down sectors.
On one hand this feeds expectations that the pendulum can and shall swing back in favour of yesterday's losers and underperformers with potentially big gains up for grabs for investors as cheap valuations and strong profit growth can turn into a powerful combination. On the other hand, all this also suggests forward profit growth projections can easily change dramatically in a very short time-frame as projections for miners and energy producers are notoriously fickle and they can prove fragile when things do not develop according to plan.
A few easy observations can be made ahead of the Australian reporting season regarding FY13 ("the year ahead"):
- profit growth forecasts for the major banks remain low (single digits at best)
- expectations remain low for many of the beaten down industrials in crisis mode. For example, no growth is expected for Billabong ((BBG)) next year, while APN News & Media ((APN)) is anticipated to still see hardly any positive growth
- solid expectations remain for engineers and providers of services to miners and energy companies. In fact, there's now market speculation the primus inter pares in the sector, Monadelphous ((MND)), will be announcing a surprise special dividend in August
- expectations are building that companies with leverage to property market recoveries in the US and domestically will experience a big boost to their earnings
- for many of the industrial companies that have performed solidly in years past, the growth outlook is expected to remain robust albeit in many cases at slightly lower growth numbers. Think Coca-Cola Amatil ((CCL)), Transurban ((TCL)), Telstra ((TLS)), Invocare ((IVC)), amongst others
- for certain resources companies the expectation is for simply another year of sheer misery with negative growth projected for the likes of Aquila Resources ((AQA)), Whitehaven Coal ((WHC)) and Western Areas ((WSA)), amongst (many) others
Now, let's find out how all of the above will be impacted by the release of corporate results and guidance in the five weeks ahead, shall we?
By Rudi Filapek-Vandyck
P.S. Note that FNArena offers subscribers 24/7 access to the most up to date consensus forecasts for the Australian share market.