Only earnings growth will send market soaring

Even though the volumes being traded are still piddling, the spike in the index has put a skip into the step of market professionals. Broker/client conversations are punctuated with bursts of laughter and the impatience to buy stocks before they go higher seems to be back. This has all taken place in a few short months.

In the past week, I have surveyed 17 fund managers and stockbrokers, and every one of them can see the S&P/ASX 200 racing to 4800 to 5000 points, or up by between 5 per cent and 9 per cent from today.

This view is primarily based on declining interest rates twisting investors' arms to put money into higher risk assets. The big winners from this flow of money during 2012 have been the high-yielding stocks such as property trusts, telecommunications companies and the banks.

In more recent times, though, investors have started to discover the cyclical sectors such as building materials and non-bank financials. There is also emerging appetite for the much-maligned resources sector.

Unsurprisingly, not one of the 17 surveyed believes the market will rally beyond this point. From a technical point of view, the market has tried to breach 5000 points twice since the global financial crisis, only to suffer from altitude sickness and start a steep descent.

The other major reason offered is "no E". When it comes to the stockmarket, the E stands for earnings, and when a funds manger or broker says there's "no E", they are suggesting there is no earnings growth. One broker commented that stocks have risen more than 10 per cent in recent months and his company has downgraded earnings across the board by 7 per cent.

The bearish sentiment that has dominated thinking for five years was again present last week, with Goldman Sachs telling clients the US market was due for another 15 per cent correction before the end of the year. This would be triggered by the damaging impact of the looming fiscal cliff.

Eventually, the stockmarket will only rise over the long haul if companies generate earnings growth. At the moment, stocks are rising because the price-to-earnings ratios are expanding. This has effectively been happening in the US for much of the past 18 months, with the S&P 500 index trading on a hefty PE of 17.5 times historical earnings.

In other words, profit growth in the US will have to resume soon to justify stock prices.

Australia is at the other end of the spectrum, where the PE for industrial stocks is only 12.5 times.

In Australia, companies from miners to banks to industrials are still telling investors that things are tough and earnings growth is difficult to achieve. The annual meeting season will confirm this.

First cab off the rank was property group Stockland. The company's stapled security was hitting 12-month highs before the board revealed that residential property conditions were worsening. The stapled security fell due to the announcement but has seemingly stabilised quickly, as investors look to a better future.

This negative operational environment does not necessarily mean we should be bearish. The overall PE of the Australian industrial market could go from 12.5 times to 15 times before earnings growth re-appears.

We only have to observe events in the US to understand this scenario in a low interest rate environment. Likewise, in 1992 the PE for the Australian market rocketed to around 20 times as investors bought stocks in anticipation of earnings growth.

While my survey failed to unearth overt bullishness about the market, there are some dissenting voices in the public domain.

Richard Coppleson, the author of the Goldman Sachs Australian afternoon report, stated last week that it felt much like 2003. In that year, the local market bottomed in March and kept scaling higher without a pull-back of more than 5 per cent. By the end of the year, the S&P/ASX 200 had risen by 18.4 per cent at the 12-month mark it was up 26.5 per cent and by November 2007 it was 154 per cent higher.

Backing Coppleson's bullish sentiment is Westpac chief economist Bill Evans, who believes official interest rates will remain low for several years to offset the impact of the moderating mining sector. He believes the big winners from this will be residential property and the stockmarket.

To me, the market feels more like 1993. The benchmark All Ordinaries Index bottomed in November 1992 after a long recession and a protracted bear market. It rose a confounding 67 per cent over the next 16 months on the back of historically low interest rates. It was only when rates started to tick higher around the globe that equities pulled back during 1994.

For the moment, though, we shouldn't get ahead of ourselves. Let's just see if we can get through the 5000 barrier, something the market has not achieved since 2010.

matthewjkidman@gmail.com