The market's still in buy territory

A feature of recent commentary by stockmarket analysts is their resounding claim that we have commenced a new bull market.

In my view, their commentary has three key features:

1. It is bereft of earnings analysis that would support rising share prices. There is no forecast of growing forward earnings and dividends;
2. It ignores the extraordinary and unsustainable economic policy settings represented by quantitative easing (QE) across four major economies. It therefore ignores the possibilities of what might happen should QE cease; and
3. It is in stark contrast to the gloomy commentaries of a mere nine months ago, as parts of Europe were feared to be moving towards default. Many who are bullish today were decidedly bearish when share prices were falling.

Right now it is easy to point to share price rises and claim that the market has suddenly moved into a new upwards price cycle. Whilst it is true that the commencement of a bull market always starts in the doom or gloom of recession – “it is always darkest before dawn” – it is also true that a sustainable bull market can only be sustained through a positive economic cycle. Markets will initially rally hard due to a perception of rising future profits. They will subsequently fall if earnings growth does not become a reality. Importantly, earnings growth is highly leveraged to economic growth and so a solid growing economy is what we must observe before we get too excited.

So are we experiencing the commencement of a bull market cycle? Or is the market merely recovering from an oversold position?

To examine this issue the following table has calculated the intrinsic value (IV) of some of my preferred stocks (as presented in the Eureka Growth and Income Portfolios) for 2013 and 2014, based on market consensus earnings. In calculating IV, I have adopted slightly “lower required returns” (RRs) than I have previously published. In doing so I am acknowledging and accepting the rally in Australian bonds that currently yield 3.5% (10 years). The 10-year bond rate is akin to the “risk-free rate of return” from which all investment assets are priced. Later I will question the sustainability of current bond yields, but they are set by the market and that is all you need to know at present.

The decision to lower the RRs in this analysis is consistent with the observation that investor risk appetite has increased against the backdrop of historically low Australian bond yields. Lower RRs are commonly associated with price-earnings ratios (P/E) that rise on the perception of future growth in earnings emerging from either a recession or a period of lower growth. Remember the market is always looking forward, and a lift in confidence may see it (the market in general), or commission agents (brokers), to perceive or imagine growing earnings. With lower interest rates and renewed confidence for the world economy, then P/Es will rise to capture the likely earnings growth. However, there is always the risk that investors will overpay and so I strongly rely on IV as a rational and stable approach to continually assess value.

To derive the valuations below I have adjusted down my RRs, projected forward and added the 2013 IV to the 2014 IV. I then divide by two (derive a midpoint) and look for a 10% margin of safety below the midpoint. This becomes a potential buy price (and fair value) for value investors taking a long-term investment view. The valuation absolutely assumes the maintenance of low interest rates and the achievement of market consensus earnings growth.

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What this analysis shows is that there is only a small margin of safety at present, against my derived IV, for most of the preferred stocks.

Let’s break them up into three categories:

1. Best value with margin of safety to buy now being MIN, BHP, MMS, WBC;
2. In value against 2014 IV, but insufficient margin of safety being CBA, BKL, TRS, BKW, RIO,WOW and FLT; and
3. Exceeds 2014 IV estimate: IRE.

So following a 20% rise in the Australian equity market since June 30, 2012, this analysis suggests that the market is now approaching fair value from a value perspective and based on market consensus earnings. However, importantly, there is currently no evidence of rampant market overvaluation as witnessed in 2007, and the best value appears to be offered in resource related stocks.

By way of example of what may lay ahead for investors who overpay for stocks, I derived an IV (as above) of $55.64 for Cochlear (COH) using market forecasts. COH was trading at a remarkable $82 before its results and has fallen by $12 per share in the aftermarket. Unfortunately for owners, this is absolutely justifiable with more falls likely.

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In conclusion, the crucial thing to remember is that market prices of shares may go much higher. Prices often move independently of value. If they do in a vacuum of earnings increases, then it will be the result of lower RRs. This is explainable, but it is a perverse trend that is a direct result of QE and its effect on bond yields (the risk-free rate). So, from now on, it is important to monitor bond yields, particularly given my view that inflation is a serious risk in 2014-15. I will regularly review international bond markets in future reports to keep you alerted to moves in the risk-free markets.

John Abernethy is the chief investment officer at Clime Investment Management. 

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Clime Income Model Portfolio

Return since June 30, 2012: 19.73%

Returns since Inception (April 24, 2012): 18.52%

Average Yield: 7.76%

Start Value: $118,757.19

Current Value: $142,187.79