More darkness before the dawn

PORTFOLIO POINT: The soft outlook for earnings growth suggests markets will fall further before they bounce.

Equities are cheap. Price/earnings multiples and price-to-book valuations are well below levels seen over the past three decades, while corporate dividend yields either rival or exceed yields on government bonds and bank deposits, depending on which country we're focusing on.

But of course you knew all that already. These are all good hooks for brokers trying to get you back into the market.

Alas, history also shows us "valuation" is a relative concept and it won't necessarily stop share prices from falling.

In fact, the consensus in Australia has been that the sharemarket has been "cheap" ever since its first failed attempt to rally past the 5000 barrier post-GFC in April 2010. Yet, here we are, 16 months further and the index is close to a 1000 points lower and still looking wobbly.

Investors are being reminded that equities have invariably looked "expensive" and "cheap" at key turning points in the past, and both observations would not always have made for accurate signals about the intermediate way forward.

In hindsight, global equities looked pretty bloated in 1998 but who knew things would get a lot crazier still, and it wasn't until March 2000 that the TMT-mania (technology, media, telecommunications) finally burst. Also, it can equally be argued equities didn't really sell off deeply enough in the bear market that followed, but less than four years later global equities were once again enjoying another steep uptrend.

In hindsight, equities really were too pricey by late 2007, yet history shows valuations were nowhere near previous bubble-peaks seen in 2000, 1965, 1929 or 1900.

History also shows that when it comes to valuations becoming cheaper, the current post-GFC de-rating can potentially stretch a lot deeper, still. Note, for example, sharemarket valuations dived even deeper post 1965 and they didn't bottom out until 1982.

These are the 18 years I often use as a reference point for today's situation. Sharemarkets showed a lot of strength, and weakness, during those years, but neither situation persisted and ultimately no net gains were booked.

I guess the good news from all of this is that a continuation of the process of de-rating for equities post 2000 (not 2007) is that this doesn't necessarily mean share prices can only head lower from here. The de-rating that occurred between 1965 and 1982 pulled P/E ratios significantly lower than where they are today, yet price charts clearly show a sideways moving market.

Similarly, while some ultra-bearish commentators continue to make references to the 1930s, the observation from 1965–1982 equally stands: P/Es fell much deeper, but, post the initial sharp sell-off in late 1929–1931, equities clearly traded sideways until the next bull market started in 1942.

Let's look at a few charts to illustrate the above. Here's one I have used a lot since 2007, clearly distinguishing the times when equities are in an uptrend, otherwise referred to as "bull market", and times when this clearly is not the case (underlined in red):

Here's the P/E de-rating that went on in the background behind all the daily price movements (chart from The Aden Report):

Closely analysing the second chart, I think there's one other observation that should have every investor's attention: history shows bull markets go hand-in-hand with rising P/E multiples, but also that P/Es first have to become really, really cheap before they embark on a sustainable uptrend.

If correct, and if we assume history will be an accurate guide for the years ahead, this suggests we are still nowhere near completion of the post 2000 de-rating process. In other words: don't hold your breath for the next sustainable uptrend, it simply is too early for that.

A similar picture emerges when we look at other valuation methods, such as price to book and dividend yields. The Australian sharemarket remains the dividend capital of the world, with the ASX 200 yielding about 5% on average, but Australian banks are offering more than 7% fully franked and there are quite a few industrial stocks that yield even more, such as beaten down retailers and media companies.

The caveat is, however, these yields are never guaranteed and yields of 8% or more are more often than not a sign of elevated risks, not necessarily of market mis-pricings.

Internationally, average dividend yields are now higher than the yield on 10-year government bonds in all but one developed country – the US – but the global average still doesn't reach higher than 3%. In 2009 the global average dividend yield rose above 4%. In the 1970s and 1980s yields rose to between 5% and 6%.

Combining all of the above suggests the future "valuation" for global equities is very much dependent on earnings growth and here the signs might not be that favourable in the near term. Reading through international research, it would seem there are plenty of arguments in favour of another downturn in corporate profitability.

From listed companies in China and other Asian emerging countries, to Europe, to the all-important US, companies are battling rising costs and unfavourable market dynamics, or so it appears, triggering concerns among securities analysts that the world is about to face another period of downgrades to corporate earnings forecasts.

US corporates have in essence done a David Jones post the Lehman Brothers collapse: amidst a sharp deterioration in the overall economic environment, they slashed and burned costs and focused on efficiency, which helped restoring profit margins at peak levels. This also means US companies cannot employ similar tactic in case of another slump or downturn.

Investors in Australia know all too well what happened with David Jones's profits and its "valuation". Despite global financial troubles, and a severe slump in equity markets, David Jones continued improving its earnings per share from 22.68¢ in 2006-07 to 33¢ in 2009-10, while steadfastly lifting its dividends, but when retail spending faced another slump this year management simply could no longer cope. This admission caused a general de-rating for the shares.

David Jones shares traded at $5.50 in late 2007. They had re-gained that price level by late 2009. Today, they cost less than $3. The implied dividend yield has blown out to more than 10%.

Something to take into consideration, perhaps, is that in the absence of a strong rally later this year, 2011 is shaping up as a likely loss-year for the Australian sharemarket. Investors should all be aware that although it is unusually to have two consecutive loss years, it is by no means unprecedented.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.