The bucket overflows with dubious optimism

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 ones who believe that the markets are predictable. The second one contains ones who believe that they are not.

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 ones who believe that the markets are predictable. The second one contains ones who believe that 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.

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 Index is still up more than 9 per cent so far this year, and up by about 17 per cent since mid-November.

That's better than overseas markets have done. As of Thursday US time, Wall Street's Dow Jones Average was up by just over 7 per cent this year, and up by the same percentage over six months. The Euro Stoxx Index was level 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 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 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 2012, 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-earnings ratio discount to the MSCI global basket of consumer discretionary stocks in the past five years and are now trading at a premium of 22 per cent. Telcos traded at a 2 per cent discount to their MSCI equivalents in the past five years, and are now at 22 per cent premium (Telstra's rally is behind that). Materials stocks including the big miners traded at a 6 per cent price-earnings ratio discount to their MSCI global peers over five years, and are now at a 6 per cent premium.

Higher prices here would be justified if the earnings outlook was bright, but the December-half profit season was dull.

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 complicated and 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 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 only rise by 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 strength, and the December-half results have done nothing to suggest that it is coming. What I am not sure about, however, is whether prices will adjust downwards.

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. 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-of-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 anxiety than did the fiscal cliff standoff at the end of last year that resulted in tax increases being avoided, and spending cuts being pushed out to the end of this week.

This year's 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 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 only going to be about 2 per cent at best without them.

The fear factor over Italy and the US cuts could still ramp up.

Yet, the calm response last week to the political bushfires on either side of the Atlantic and a profit season that was just OK confirms that there has been a mood change. 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.

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