General investors. Portfolio construction.
As a professional adviser I am a grateful recipient of a “rich” amount of information from various institutions also fervently studying markets. Amongst those I value is a quarterly update from JP Morgan – filled with over 300 charts, which might even paralyse Alan Kohler with indecision (no, not really). Here is a sample of some of those charts and a few from other places that tell an important story about the current state of the market and some risks and opportunities I think you need to consider.
Lacklustre corporate earnings behind lacklustre market
These charts show Australian and US company earnings (grey shaded region) and prices (index level in gold) since the GFC. They point out:
- Australian share prices are justifiable below their GFC peak because earnings are lower
- The latest decline is due to falling energy and resource prices. Prior to that it was capital raising by banks, which increased shares on issue, and so depressed earnings per share.
- Since our market is nearly two-thirds banks and energy, you need resource prices to rise and banks to sell more debt or for more, to expect our market to rise materially. Expect not?
- The US market is justifiably up because companies there grew profits impressively.
- However, US company earnings are stalling. Cheap interest rates used to refinance debt and finance buying shares may be coming to an end and maybe also low wages. US corporate profit margins are stretched compared to historic values and probably can’t be stretched further to grow earnings further.
- If you were late investing in the US, don’t expect to enjoy recent gains.
Developed economy shares are getting pricey…be warned
Recent gains in the share market have been driven by increased price, not fundamental earnings. The local market P/E rose to 16 at the end of March and is now 17. The US market has grown from 17 to 19. Before you think our market is a better value, realise that if you exclude resource and banks or simply reweight our market to world market sector allocations, our P/E is a much higher now 20 (thanks to MLC for pointing that out to me separately). Banks, which make up 40 per cent of our index, traditionally trade on a lower P/E multiple which depresses our market P/E.
While high valuations are justified when alternatives are meagre, the risk of a correction is now probably as high as it’s been since 2007. Perhaps we should say “Sell in June but come back soon” ? Those exiting the share market would come back after a fall, hungry for low-price-enhanced income.
Bargain priced emerging market companies?
My montage selection of charts, arrows and annotations “simply” point out …
- While 60 per cent of world GDP is generated out of emerging market (EM) countries, companies domiciled there account for only 11 per cent of world stock market value (and zero per cent of most International equity index funds which exclude EM).
- EM companies were trading on a depressed 1.4 times book value, versus 2.2 for Australian companies and 2.8 for US companies.
- These low valuations have been temporary in the past. Returns 12 months later have often been double digit positive.
- However, note past returns are no guarantee of future returns and few are excited about growth prospects in this part of the world. That will change, sometime.
Pricey property trusts
The number one performing asset class over the last five years has been Australian Real Estate Investment Trusts (AREITs) and their International cousins – the latter helped with a boost from a falling Australian dollar to match. They returned 16 per cent annually, which is somewhat surprising given the rent for my humble Collins Street office has only risen three per cent annually. To avoid being found insolvent in a world of low bond yields, giant pension funds and other institutions have been embracing property trusts as bond substitutes. Their prices have soared and they are trading at 40 per cent above net tangible assets or 20 per cent above net asset value. Stephen Hiscock writes a fantastically thorough monthly report on REITs and is not afraid to point out, shown above, that future returns will be reduced by a reversal of this premium. How quickly, who knows? If you have made 15 per cent annually in REITs over the last give years, you only need to go back eight years for a reminder to take profits.
Value to become valuable?
Nervous share and momentum-style investors have been paying a premium for high growth or secure companies. For instance, investors locally are paying 14 times earnings for presumed solid CBA versus 11 times for fumbling ANZ. Low growth, low P/E companies have been neglected, causing many “value style” investment funds to underperform. This chart borrowed from Lazard shows the 90 year old trend of US low priced, value companies outperforming higher priced, growth companies faltering since the GFC (perhaps like an echo of the Great Depression?). I’ve inserted a chart from T. Rowe Price showing this same affect in Australia since 2005. It shows the ratio of high P/E stocks to low P/E stocks (or “dispersion”) has increased to 1.8x – above the usual 1.4x premium. I’ve optimistically noted with dotted lines that these valuation gaps could close, and if doing so, they offer premium (30 per cent?) returns for those willing to bet on out of favour companies.
Australian investors love dividends and Australian companies love to pay them out. We are world leaders in doing so, however, this is founded on a very high and unsustainable profit payout ratio. I prefer that investors target total return, reminding thrifty dividend paying out CSL is just as attractive as dividend-utility CBA. However, nil tax investors mustn’t discount franking credits which give local shares an about two per cent after tax advantage to offshore shares – that is until Canberra stumbles onto that pot of money.
Australia’s Achilles heel
A chart from JP Morgan comparing household balance sheets of Australians and Americans highlights a huge concentration risk that needs to be managed.
In the lower left you can see Australian household assets are 55 per cent in property compared to 25 per cent for Americans. Some of this is due to recent greater price rises (top left chart sourced elsewhere), other is just behaviour.
Forty five per cent of our post-resource boom share market is concentrated in financial companies (mostly banks), whose prospects are intimately tied to the local property market (the lower right sector chart borrowed from State Street’s ASX200 index fund). Don’t forget to also add hybrid securities issued mainly by banks further concentrating exposure.
Thirdly, Australians aren’t diversified bond investors. They’re heavy bank depositors (up 5x in the last couple decades shown in the top right chart). All up we lend 20 per cent of non-household assets to banks versus 13 per cent for Americans.
Altogether I would hazard to guess three quarters of Australian household wealth is in property and deposited or invested in banks reliant on property. This compares to about one third for Americans.
“Wait, there’s more!” State governments rely on property transaction and land taxes – in Victoria it’s the number one source of revenue, funding over 40 per cent of spending. I’m sure capital gains tax on property also add more to the Commonwealth then negatively gearing takes away. Even the RBA is involved, stimulating us to borrow more and hope we spend more feeling wealthier from rising property prices.
I’m certain there isn’t any country in the world where personal wealth is so dependent on property and mostly four companies propping that up. That’s the Australia’s giant Achilles heel.
To manage this risk you’ll need to temper your enthusiasm for property and cap your bank shares at some sensible exposure (30 per cent?). It also means avoiding local market index funds that do you a disservice not capping the concentration of banks and financial stocks in them. After that just pray that my friends at our banking regulator APRA are up to the job supervising banks, as everyone else has a conflict of interest in property related policy.
I hate these slides, not just because they are messy, but also because they highlight the mess that is the global state of indebtedness and bond yields. Over the last 25 years, the bond market has grown 10 times from $10 trillion to $100 trillion– that’s 10 per cent annual growth. You would have thought with all that extra borrowing demand, lenders would be able to charge more. Nope, yields have fallen from about 10 per cent to one per cent. Now $10 trillion of debt earns sub zero yields – that’s where you’re paid to borrow and you have to pay to lend your money! This is absurd. Japan is leading the way paying off its own debt with printed money (“monetisation”). Others will follow but a good crisis is needed to distract.
Unless otherwise referenced, charts shown were sourced kindly with permission from ‘J.P. Morgan Asset Management Guide to the Markets – Australia 2Q 2016”.