Market still rallying as investors suck up bad news and see

Feedback on articles that I have written about the sharemarket over the years can be divided into two buckets, both of which contain optimists and pessimists. The first one contains those who believe the markets are predictable. The second one contains those who believe they are not.

I am in the second bucket, and so increasingly are investment flows. Index investing, for example, has grown in the past couple of decades because fund managers who have produced above-market performance over the long-term are exceptions to a general rule that investment performance over the long term will revert to the mean.

The December half-profit season here has done nothing to make us sceptics feel more confident about the rally in share prices that began in the middle of last year and accelerated from mid-November onwards.

Shares whipsawed this week after Italy's election debacle and as America's only slightly diminished fiscal cliff once again approached, but the S&P/ASX 200 share index that accounts for about 90 per cent of trading value is still up more than 9 per cent so far this year, and up about 17 per cent since mid-November. That's a better gain than overseas markets have posted. As of Thursday US time, Wall Street's Dow Jones average was up just more than 7 per cent this year, and up by the same percentage over six months. The Euro Stoxx index was level-pegging for the year after falling in February, although it was still up almost 8 per cent in six months.

Evans and Partners' chief investment officer, Mike Hawkins, told his firm's clients this week that the ASX 300 accumulation index, which combines share price moves and dividends, had risen for nine consecutive months, with the two biggest rises of 5 per cent and 5.3 per cent logged in January and February. The best runs that Hawkins could locate in the past decade were two that went for 10 months, one beginning in May 2004 and the other beginning in August 2006.

So this is an unusual run, and investors here are now paying about 17 times the expected earnings over the next year of industrial shares in the ASX 200. They were paying about 13 times expected earnings in the middle of last year, when the market rally began.

Overseas markets have not risen as strongly, and price earnings multiple expansion has been more subdued, leaving many Australian share sectors at a premium. Consumer discretionary stocks in our market, for example, traded at an 18 per cent price-to-earnings ratio discount to the MSCI global basket of consumer discretionary stocks in the past five years and are now trading at a 22 per cent premium. Telcos traded at a 2 per cent discount to their MSCI equivalents in the past five years, and are now at a 22 per cent premium (Telstra's rally is behind that). Materials stocks including the big miners traded at 6 per cent price-to-earnings ratio discount to their MSCI global peers over five years, and are now at a 6 per cent premium.

Higher price-to-earnings multiples here would be justified if the earnings outlook was bright, but that's where the December half-profit season comes in - or rather, where it does not. Earnings forecasts have been trending down for a couple of years here and in the big markets overseas, as an expected smooth recovery from the global crisis turns out to be patchy. Two things stand out, however.

First, the earnings growth outlook is a bit better overseas than it is here, even though Australia ducked the worst of the global crisis. Earnings per share growth in 2013 and 2014 is expected to be about 9 per cent this year and 12 per cent in 2014 for the world at large; 7 per cent this year and 11 per cent next year in the US; 7 per cent and 11 per cent in Britain; 5 per cent and 13 per cent in Europe; and 13 per cent and 12 per cent in Asia excluding Japan. Earnings in Australia are expected to rise by only 6 per cent this year, and by 10 per cent next year.

Second, the December half-profit season has not moved the local dial. There were more positive earnings surprises than negative ones, but it has all come out in the wash to produce no material change to the subdued local earnings outlook. The best that can be said is that this is an improvement on the past two years: profit forecasts are at least no longer being wound back aggressively.

Healthier profit growth is needed to justify the market's present strength, and the December-half results have done nothing to suggest that earnings are accelerating strongly enough. What I am not sure about, however, is whether prices will correct soon.

The sell-off in reaction to Italy's shambolic and inconclusive election result at the start of this week was for example relatively mild in the sharemarket.

In the bond market Italian government bond yields rose, but Spanish bond yields did not move up by as much, and Portuguese, Irish and Greek debt yields were stable.

The end-week deadline in the US for the introduction of automatic spending cuts including about $US85 billion of cuts this year has also so far caused less market angst than the fiscal cliff standoff at the end of last year that eventually resulted in tax increases being avoided, and spending cuts pushed out to the March 1 deadline that has now arrived.

The economic hit is smaller than it was before the tax increases were set aside two months ago, but only by about $US25 billion, and the automatic cuts would still reduce spending by about $US1 trillion between now and 2021 if allowed to run their course. US lawmakers on both sides of the fence say they want to find an alternative, but as of Thursday US time they had failed to do so.

The Italian election is a negative development, and while the US needs to gets its debt down, so are automatic, undirected spending cuts: they would extract about a half a percentage point from US economic growth this year, and it is going to be only about 2 per cent at best without them.

The fear factor over Italy and the US cuts could still ramp up. The calm response last week to the political bushfires on either side of the Atlantic and a profit season that was just OK at best confirms that there's been a mood change, however.

Investors have shifted from discounting good news to at least partially discounting bad news, and hoping for the best, including the emergence of a pro-euro coalition in Italy and a belated debt deal in the US. Share prices are too high here. But if the mood holds up, the market may, too.

mmaiden@fairfaxmedia.com.au