Ring of confidence stays despite what earnings are doing
A friend of mine is adamant that the best way to avoid disappointment in life is to continually expect life to be a disappointment. If you fear the worst, you are pleasantly surprised when it doesn't eventuate, runs his theory; and for the second year running, profit predictions for the June 30 reporting season incorporate a similar view.
Analysts started the year to June 30, 2012, tipping aggregate earnings of $391 a share for the companies in the AS&P/ASX 200 index. The estimate was 7.5 per cent lower by Christmas as Europe's sovereign debt crisis flared again, and it was lowered by the same percentage in the second half of the financial year as mining analysts factored in the end of the bubble phase of the resources boom.
As it turned out, the pessimism was warranted. It was a very ordinary June earnings season a year ago. Profits in aggregate were about 5 per cent higher at $328 a share, with industrial company earnings rising about 7 per cent and the miners selling more minerals at lower prices just to tread water.
At the start of the year to June 30 that has just ended, the analysts were tipping that the ASX 200 universe would boost earnings to $360 a share. It wasn't a hugely adventurous call - the ASX 200 earned as much in 2006-07, the year before the global financial crisis erupted - but it too was wound back steadily as the year progressed.
With just over a week to go before the the onslaught of June 30 yearly and half-year profit reports begins, the tip is that the ASX 200 will report combined earnings of $324 a share, down 10 per cent on the estimate a year ago, and down 1 per cent on earnings in 2011-12.
Resources company earnings downgrades have done the most damage. Estimates have been wound back by 30 per cent during the year to a predicted earnings decline of 25 per cent. Industrial company earnings are still expected to rise, but only by about 4 per cent.
It's worth noting that even on the eve of the actual profits being reported, the downgraded forecasts are still not rock solid. The ASX 200 forecast is a composite of individual predictions of company profits by broking analysts, and analysts always tend to be a tad over-optimistic about the companies they track. They know the companies they track and the people who manage them, and as a result succumb as a group to a sharemarket version of Stockholm syndrome.
Earnings forecast cutbacks and the steady stream of profit downgrades from resources sector engineers and suppliers such as Orica, Worley Parsons, UGL and Coffey, and pure industrials including AMP, Goodman Fielder and Treasury Estates that have encouraged them have, however, once again created the circumstances where ordinary results should not disappoint.
It's what happens then that matters, though, and what actually happened in the market in the past year is a guide.
Earnings in the year to 2012 were as drab as the analysts eventually predicted, but the ASX 200 index is 21.5 per cent higher than it was a year ago, and only 4 per cent below its 2013 high in May.
Industrial shares in the index are 14.7 per cent higher in a year despite all the talk about consumers being on strike, and the materials index that includes the miners is 2.7 per cent higher than it was a year ago - albeit down by 17 per cent since the middle of February, when the big miners reported on their December halves and made it clear that the commodity price bubble had deflated, and that controlling costs and boosting productivity was the game.
How did this happen when profits were cactus? Because investors became less fearful of a return of the global crisis and less happy with fixed interest investments as rates continued to fall, and were as a result willing to pay more per pound of cactus. The ASX 200 family of companies has moved from a price-to-earnings multiple of 12.1 times expected earnings in the next 12 months a year ago to 14.7 times expected earnings now.
The average multiple for the ASX 200 in the past decade is lower, at 14.1 times: shares are a tad expensive on that comparison, and that tells you something.
Earnings multiples on shares might expand a bit more and carry share prices a bit higher if the world's climb away from the global crisis continues, but it's time for actual earnings growth to kick in, to push prices higher even if earnings multiples stay the same.
Those eternally optimistic sell-side broker analysts are forecasting that it will occur, of course. Their earnings estimates for the ASX 200 in 2013-14 were downgraded by 11.5 per cent during 2012-13 as part of the same reassessment that pulled their 2012-13 forecasts down, but they still tip that earnings will rise by 9.5 per cent.
The fact that similar forecasts were wound back in the past two years doesn't inspire great confidence, however, and the sharemarket is now at a crossroads of sorts. There is less scope for gains on the back of richer valuations of earnings, but if earnings in the upcoming profit reporting season are, as expected, dull but not disastrous, profit gains in 2013-14 and beyond will be delivered if we get the much discussed but so far only tentatively identified switch in activity from the resources boom to the non-resources sector.
Two out of three essential ingredients are in place: record low interest rates, and a lower Australian dollar. The third ingredient is consumer demand, and we won't know whether it is returning until the longest election campaign in Australia's history is over: please, Prime Minister, put us out of our misery.