Independence Day, but we’re not independent

The Australian market has surged … following the US market’s rally overnight. Not surprising, and there's reasons to celebrate.

Summary: When the US market rises, we tend to follow suit. As our market surged today, it was a stark reminder that we are highly dependent on what happens on Wall Street.
Key take-out: US investment research firm MRB Partners argues that stocks are especially attractive relative to bonds, and the market is not overvalued at current levels.
Key beneficiaries: General investors. Category: Economics and investment strategy.

The Australian sharemarket rebounded strongly today, adding more than 34 points to push back through 5,500.

There were no fireworks to be seen here, but our celebrations were perfectly timed for American Independence Day, or more precisely in recognition of the day before. That’s because Wall Street was celebrating a day early, as the benchmark Dow Jones Industrial Average broke through 17,000 and closed above there for the very first time.

The S&P 500, meanwhile, rose 1.2% to 1,985.44, its 25th record high of the year. And the Nasdaq Composite jumped 2% to 4,485.93, its highest close since March 31, 2000.

The Australian market, as usual, followed suit today – a sure sign that when it comes to celebrating stock index gains, we are anything but independent. When Wall Street gains weight, so do we. The trick, as any fitness industry person will confirm, is not to gain too much weight, too quickly.

Barron’s market columnist Ben Levisohn says the US market is not looking overly expensive. “The Dow Jones is now trading at 15.7 times the last 12-months of earnings, only slightly above its historical average of 15 times. The S&P 500, meanwhile, trades at 17.6 times trailing earnings, above its long term average of around 15.5, but not at a level that screams overvaluation.”

Eureka Report’s economist Adam Carr agrees: “The current S&P500 P/E is now only just above its pre-GFC average. Similarly, the All Ords, is pretty much smack bang on average. Combine that fact with the significant debasement of currency underway – well, the reality is stocks are still very cheap – and cheaper than bonds and other assets. Which, of course, is why central banks are increasingly diversifying out of cash and bonds and into equities. They know the game.”

US investment research firm MRB Partners argues that stocks are especially attractive relative to bonds.

“…based on the MRB Cyclically-Adjusted P/E Ratio, the earnings yield on stocks is nearly 6%, broadly in-line with the post-1990 average. By contrast, the real yield on G7 government bonds is close to 0%, resulting in a gap with equities that is wide by historical standards.”

MRB says equity valuations are not compelling in absolute terms; they are slightly above a neutral reading. Yet measured against significantly overvalued bonds, stocks are appealing at this stage of the economic cycle.

The highlight of the week was Thursday’s Department of Labor employment report, which showed the US economy added a healthy 288,000 jobs in June, while the unemployment rate fell to 6.1% from 6.3% in May.

With the positive data this week showing growth in the US it’s a bit of a hit to the bear thesis that the market is trading on too high a P/E. More growth will flow into earnings for next year, reducing the market’s forecast P/E ratio.

Economists characterised the Labor data as the latest indication of pick-up in the US economy after activity plummeted in the first quarter, mainly due to unusually cold weather. Other data showed a lower US trade deficit in May and a big jump in pending home sales in May.

However, some analysts viewed the market’s buoyant reaction with concern. The positive data could put a risk to US interest rates rising earlier next year rather than mid-2015.

“Investors are growing concerned with the increased bullishness in the market and ... wondering if the time is growing close to a correction,” said David Levy, portfolio manager at Kenjol Capital Management.

Levy said the market could retreat in the coming weeks if second-quarter earnings disappoint, or if investors conclude the Federal Reserve is likely to move up its timetable for raising interest rates.

But Scott Wren, a senior equity strategist at Wells Fargo Advisers, said the market has plenty of running room.

“Earnings are at a record high, valuations are reasonable, and the global recovery, albeit slow, continues to ramble on,” Wren said in a note. “The cyclical bull market, at least in our opinion, still looks like it has several more years to run.”

Levisohn says that much has been made of the Dow’s 153 trading-day journey from 16,000 to 17,000, the seventh-fastest 1000-point gain since the measure was launched. But it may be getting easier for the Dow Jones to break those big round numbers. Indeed, a 1,000 point move in the DJIA is not what it used to be.

Back in the mid-1990s, when the DJIA was crossing 1,000 point thresholds at a fast clip, each of those moves required a sizable gain. With the law of large numbers kicking in these days, though, a 1,000 point move requires a rally of just 6%. And once the DJIA does close above 17,000, the road to 18,000 will require a gain of less than 6%.

What does all this mean for the Australian market. Well, one should expect more of the same really. After all, we’re not really that independent from the market events transpiring in the US and elsewhere. Happy Independence Day.

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