The Great Sharemarket Return: The next phase

Here’s a little nugget that may just get you through your Friday night trivia ordeal, if your fellow combatants and the quizmaster are financially minded of course.

Name the world’s five best-performing assets over the past year?

If you came up with Greek Government bonds being in first spot, you’ve nailed it. Those once toxic bits of paper have returned a phenomenal 122.6% over the past year, followed in short order by Portugal Government bonds, Turkish equities, Swiss equities, and (drum roll please) Australian equities.

That’s right. With a 26.2% return, our stockmarket is ranked fifth in terms of total returns in the past year when compared with all other bourses and bond markets, both government and corporate.

Bearing in mind the top two were absolute stinkers on the rebound, and the third a relative non-entity in global investing, it illustrates both the extent of the rally in domestic shares during the past nine months and the low base from which it has pounced.

Wall Street managed 12^th spot with a 17.2% return, and the global equities index managed just 18^th with a 14.3% return. (Click here to see today's video with Robert Gottliebsen).

Not surprisingly, the calls now are growing louder that the Australian market is too expensive and that a correction is imminent. Given the speed with which the market has run, that would be a reasonable short-term assumption.

There is, however, still plenty of medium-term growth left in Australian equities. But no longer will it be a simple strategy of shifting cash out of lower-yielding cash management and term deposit accounts and into higher-yielding quality equities.

That game is almost done. The hunt for yield, while still important, is gradually being replaced by a hunt for value.

There is a general consensus that while the Australian market appears to have run ahead of itself and is poised for a correction, a fundamental shift has occurred.

After three years of profit warnings and downgrades, the latest half-year results generated enough hope among investors and even pessimistic analysts and equity strategists that the worst had passed.

Robert Gottliebsen recently interviewed Robert Manning, the head of global funds manager MFS Investment Management, who poured a bucket of cold water over the heads of Australian investors. (See The US fund manager with a danger alert).

The Australian market was too expensive, he claimed. Our PE ratios were higher than those in the US, even though we have higher interest rates.

There’s no denying his logic. But there is a bigger story behind the sudden rerating of the Australian stockmarket, and it is all to do with the E in PE.

American stocks may be cheaper on that bald ratio, but that follows four years of US Federal Reserve chairman Ben Bernanke’s frantic efforts to depress the value of the greenback, put America into a globally more competitive position, and drive corporate earnings.  It has worked spectacularly.

That resurgence in American corporate earnings has fuelled a four-year rally on Wall Street, which this month hit new records. Our market, in stark contrast, is still close to 20% below its 2007 peak.

For the past three years our industrial, manufacturing and service sector earnings have been battered by a currency propelled to post-float records by a lethal combination of a resources boom, the highest interest rates in the developed world, and an artificially depressed greenback.

It is no coincidence that Switzerland too was hit out of the competitive arena by an overvalued franc, and that its bourse is responding now in similar fashion to ours.

In other words, the earnings tide now is turning.

The Rotation Effect

The Great Rotation – out of fixed interest and into equities; out of safety and into higher risk – has been a global phenomenon.

For Australian investors, however, the trend to date has been a lop-sided affair. High-quality stocks with solid dividends, particularly the banks, have driven the rally.

Industrials have outpaced resources. Large caps have outperformed mid-sized and smaller companies.

Banks and defensives have led the charge, while cyclicals, on the other hand, have lagged and resources have largely been left behind.

While more expensive than global peers, on an overall basis, the Australian market is priced right on its 20-year median at a little over 14 times earnings. Given this has occurred at a time of record low interest rates, from a historical perspective there is a good argument to suggest current levels are sustainable, particularly if there is a pick-up in earnings.

With the main drivers now looking expensive, all eyes are beginning to focus on the laggards, particularly on companies that are fundamentally undervalued, and especially on domestically focussed cyclical stocks that will benefit from an extended period of low interest rates.

In the past week alone, UBS, Credit Suisse and Deutsche Bank all have mounted the case that the earnings cycle either has bottomed, or is close to it, as record low interest rates, an easing currency and a steely focus on costs combine to lift earnings.

The shift towards value stocks already has begun, according to UBS.

“This is in many ways reminiscent of 2009, as value plays recovered from deep discounts to book value,” it noted earlier this month, pointing out that this rally was still small compared with that of 2009 and that many value stocks were still trading below the levels of the post financial crisis rally.

“We think the combination of declining risk aversion, cheap valuations, investor short covering, and initiatives at the company level to improve profitability is a fertile backdrop for an extended value rally,” it said.

“Better macro conditions combined with a weaker Australian dollar would improve the backdrop even more,” it added.

Preferred value stocks include the likes of Arrium, Asciano, Aristocrat Leisure, Boral, Incitec Pivot, Origin Energy and UGL. It recently added Qantas and JB Hi-Fi to the list.

The Stevens Put

Is the RBA chief really that powerful? Credit Suisse seems to think so. Reserve Bank governor Glenn Stevens, it argues, has put in place a monetary policy and a propaganda campaign that will support the domestic stockmarket, particularly value stocks.

The heavy RBA rate cutting program since late 2011 provided the foundation. But in indicating its willingness to cut further in the event of trouble, the RBA has provided a 'put' to support the market, similar to the so-called Bernanke Put of the US Federal Reserve (named after Fed chairman Ben Bernanke). A put is a right, but not an obligation, to sell a specified amount of an underlying security at a specified price within a specified time. In this case, it is the right to loosen monetary policy (interest rates).

It is already working. Its willingness to insure against bad news has removed 50 basis points from bond yields.

“This is as good as 50 basis points of easing,” Credit Suisse says. This, it argues, helps explain the PE expansion we have seen. Investors are relying on RBA help, even before it has been extended.

While it warns this is not sustainable in the long term, as it could breed moral hazard (risk-taking), it is currently putting a floor underneath earnings from domestic companies and providing comfort on their values.

Despite the huge run on financials, Credit Suisse still recommends the likes of the big four banks, along with Suncorp, IAG, Bendigo and Adelaide Bank, Bank of Queensland, Macquarie Group, Lend Lease and Challenger.

On domestic cyclicals, it likes Carsales, Myer, Downer EDI and Flight Centre. Among the utilities, Telstra, Spark Infrastructure and SP AusNet get a guernsey.

“Resources stocks feature among our least preferred,” it says, citing Iluka, Woodside, Whitehaven, Oz Minerals, Oil Search, Atlas Iron, Newcrest, Persesus, Aurora and PanAust.

Earnings Momentum

Deutsche Bank has joined the ranks of investment banks that have warmed to the idea of an earnings resurgence, arguing that earnings for industrials and banks already have turned the corner.

“The market PE is quite high, but the positive earnings and flows backdrop could push the market higher,” it told clients last week.

After being heavily negative for two years, earnings revisions have returned to neutral. When combined with low margin forecasts, this has boosted confidence among Deutsche analysts that good earnings growth can be achieved in the next few years.

The banks look expensive, it argues, but solid yield support should maintain demand for the big banks. Given the poor performance of resources in recent times, it is looking for some possible improvements, particularly if commodity prices bounce back. But it retains a preference for energy.

Recent additions to the portfolio include Toll, Asciano, Bluescope, News Corp, Macquarie, AMP, QBE and NAB.

Deutsche reckons that momentum will play a role too. As the market continues to improve, investors increasingly will shift funds out of low-yielding safe havens and into equities. That should add to the hunt for value, rather than just yield.