Market's direction is reliant on interest rate movements

The single most important factor Australian sharemarket investors should be considering now in the cycle is interest rates.

The single most important factor Australian sharemarket investors should be considering now in the cycle is interest rates.

When 2013 kicked off, most market commentators, including me, were betting interest rates would continue to fall. The consensus was the Reserve Bank would lower the cash rate by somewhere between 25 and 50 basis points, while three and 10-year bonds would drift lower.

That consensus has changed and the market is now betting the interest rate cutting cycle is ending. Only time will tell, but if rates start to climb, investors should be cautious.

The most sensitive stocks to rising rates are the big banks, as they are the most leveraged companies in Australia.

The banking sector now accounts for 30 per cent of the Australian market. On most valuation methodologies, including price-earnings ratios and price to book, our four big banks are at the top of their historical ranges. They haven't reached the ridiculous stage yet but they are far from compelling value. The current valuations can only be justified when compared with cash rates and bond yields.

If interest rates stall and stay at this level then bank valuations can rise in line with their earnings. If, on the other hand, yields start to push higher then we have to assume the banking sector will relinquish its role as leader of this market rally.

QBE Insurance

Investors have warmly received the message being delivered by the new management team at global general insurer QBE.

At the end of February, the company announced a disappointing earnings number for the year to December 31 only to see its share price shunted 15 per cent higher. The stock is now up 37 per cent since early December and is trading at the top of the range that has been in place since early 2012.

The company, under new CEO John Neal, is attempting a turnaround after an acquisition-fuelled era under former boss Frank O'Halloran.

Driving the decision-making in the immediate term is what seems to be an agreement with ratings agency S&P to reduce gearing from 43 per cent to 35 per cent.

The credit rating of an insurance company is critical for business and S&P has QBE on negative watch. If QBE misses the gearing target, a capital raising of some form might still be needed.

Neal has targeted $250 million of cost reductions and reduced the dividend payout ratio from 70 per cent to 50 per cent to make the stated gearing target. On current trading, he is a better than even chance of getting there.

The worrying aspect about QBE's current share price is that no discount exists for another capital raising some time around midyear. In fact, most analysts believe the company is still overvalued by about $1 a share, even if it keeps its current credit rating and does not have to raise fresh equity to appease S&P.

Austock

Switching to the micro end of the market, former stockbroking company Austock still looks an interesting play. Decimated by the global financial crisis, Austock's share price plumbed to a low of 7.1¢ in April 2012. Since then the stock has rallied strongly to 19¢ a share, a gain of 167 per cent.

In that time, the company has moved out of stockbroking and sold its property management business to Folkestone for more than $14 million. Austock used about $4 million of the funds from the sale to buy back about 34 million of its own shares.

Today, Austock has a market capitalisation of $19 million. It has net assets on its balance sheet of $14 million, of which about $13 million is cash or cash equivalents. This means investors are paying $6 million for the company's niche life insurance business.

Austock specialises in insurance investment bonds that are tax effective and allow individuals to plan for key liabilities in their life such as their children's education.

matthewjkidman@gmail.com

Fairfax Media does not take responsibility for stock tips.

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