PORTFOLIO POINT: Australian economic data shows we are on a growth curve, meaning there’s good value buying in cyclical stocks in certain sectors.
You’ve no doubt seen charts like the one below. It shows the apparent stockmarket and economic cycles, the former leading the latter, and which sectors are best to invest in at each point. There are plenty of them about and I just poached this one randomly from the internet. They all pretty much say the same thing though. You pile into pro-growth cyclicals at the early stage of a recovery and then throw yourselves into defensives as the market starts to turn or has turned. Simple right? If only.
Chart 1: Stockmarket cycle
The problem is that there is always debate about where it is in the cycle we are exactly. Well, at least there used to be in the Australian context. That debate was largely settled by recent growth figures which have made it plain. And this is shown in chart 2.
Chart 2: Australian economic growth
The data shows we are into the middle phases of a strong growth recovery. Not that it 'feels’ like it though and there are certainly discrepancies by sector and within sectors. Suggesting that the economy is 'two speed’ doesn’t quite do it justice. The disparities are much wider and more complicated than that. But, and for a couple of years at least, we’ve seen strong growth in household consumption, wholesale trade and some manufacturing (clothing, machinery, metals). Similarly, services such as transport, financials, public admin, health and recreation are all growing at strong, above trend rates. Then, of course, we’ve also seen strong growth across agriculture and engineering construction. You see it’s not just about mining at all. This has been an unfortunate misnomer for some time (shown graphically in Chart 3).
Chart 3: Growth in non-mining sectors (12 months to March 2012)
Against that backdrop the Australian equity market has been extraordinary and we know that the market’s performance, overall, doesn’t reflect these strong growth fundamentals (chart 4 below).
Chart 4: All Ords and S&P500 (indexes rebased)
Looking at the split by sector (Table 1 below) shows the market is well and truly entrenched in bear mode and consistent with this, health, utilities and telecoms have been the key outperformers – which is what you’d expect in the early to middle phase of a bear market.
Table 1: Equity performance by sector
Let’s reflect on Chart 1 for a moment then. The economic cycle suggests we should be in the mature phases of a bull market. Clearly we’re not. Then again, the stockmarket cycle suggests the economy should have peaked over the last year. History shows that this isn’t the case and the peak has yet to come. It’s fair to say there are plenty of people who suggest the peak may come soon and that it’s downhill from there. But I think it is much more likely that the peak is some way off.
For a start, look at the credit cycle – it’s firmly in recessionary territory and we know the property market is very sluggish. Even so, we’re still pulling well above trend growth driven by all of the sectors I mentioned above – not just mining. This is important, because the Australian economy has never peaked at the bottom of the credit cycle – see chart 5 below.
Chart 5: Credit growth and the Australian economic cycle
You can see from the chart that a trough in credit has never been associated with a peak in GDP or given a signal that GDP is about to deteriorate. Indeed it’s usually the opposite. GDP leads the credit cycle, you can see that pretty clearly, and it makes sense logically when you think about the process. Growth picks up, eventually jobs are created, confidence bounces back and people feel safe borrowing – credit expands. For sure, there is a particularly wide divergence between GDP and credit growth now, however the fact that the credit cycle is already at historical lows, and has been for a few years already, suggests we’re at the trough.
Other reasons to believe the peak in GDP is some way off include the buffer that strong consumer savings bring. Consider interest rates are low and unlikely to go up soon. The unemployment rate is low etc. This, alongside the absence of any imbalances which generally cause recessions (i.e., a housing or investment glut) suggests the Australian economy has a good way to run yet.
Now that’s all fine and well, but there is Europe and other global concerns to think about. Legitimate fears to be sure, but I’ve explained elsewhere why I don’t’ think Europe will implode and why they’ll continue to plod along – a view supported by Friday’s EU summit, but also see my posts Why Greece won’t cause a Lehman moment and Europe’s untold riches.
What investors do from this point, will, by and large depend on risk appetite and time horizon. On my view, and I sincerely believe it to be the stronger analytical case by far, investors should be buying up cyclicals with a 3-5 year view. The mismatch between the growth cycle and the stock cycle is too good to pass up for mine. In all likelihood the fundamentals will reassert at some point, although I’m not pretending to know exactly when that will be.
Whatever the case, a lot of these sectors are very cheap as shown in Table 2 – pretty much the same as Table 1 with the additional information provided by the P/E ratio and dividend yield – courtesy of IRESS. Now your P/E and D/Y are not perfect indicators, and I would never suggest you should rely solely on them. They have their flaws, especially forward estimates which are based on forecasts that may not materialise. The below are 12-month trailing estimates and not based on forecasts – they are actual. Trailing estimates have their own flaws though, as history is not a perfect guide to the future.
Nevertheless, combined with a sound understanding of our exact point in the cycle they offer great information on relative valuation as it currently stands.
Table 2: Equity performance by sector – Price-earnings and dividend yield
From Chart 1, the stage of the economic cycle suggests that our equity portfolio should be tilted towards your materials, financials, industrials and the like. These are the sectors that fundamentally should outperform. The fact they haven’t only adds to the case – it suggests value and a quick look at their P/Es confirms this. But it also shows that some have better value than others. Industrials, for instance, despite having fallen 10% over the last six months have a price multiple of almost 19 times. This looks expensive relative to the average (shown in brackets) of 15. Not really a compelling case to buy in this environment, no real value as a sector. I mean earnings could improve, sure, but this is already factored into the price. Materials conversely look positively cheap with a P/E of 10.3, well below the average of about 16. Risky? Of course. Has earnings growth been hammered? Yes. But it’s all in the price already. Buy low, sell high right?
Financials to me are the outstanding buy for a few of reasons. The stage of cycle analysis suggests we are at the bottom the credit cycle. There is only upside to earnings growth on a 3-5 year view. They are cheap – P/E of 11.6 vs the average of 13.4 and offer a great dividend yield which is above whatever they pay on a term deposit – even if they end up cutting the dividend.
Now I can appreciate that many readers will not share my view and that is fine. Differences of opinion make a market after all. That said, some of your defensives have already had a pretty good run over the last 12 months as you can see from the table. Their P/E ratios don’t suggest any are particularly rich or expensive relative to history – maybe energy stocks which are currently fairly valued, notwithstanding an 18% fall over the last 18 months. So energy stocks I’d probably keep away from then – little value and a bad dividend. Same with health stocks. They’ve had a good run, aren’t too far below fair value and pay a comparatively bad dividend yield. So for me, health stocks are a sell, and if you are bearish I’d switch out of health and into your utilities and telecoms. The latter two have had a good run also, 10-16% over the last 6 months, but their P/E’s suggest they still offer some value and of course you’ve got the dividend yield.
In conclusion then, stage-of-cycle analysis and recent equity market performance suggests there is tremendous value in some cyclicals. Especially financials and materials on a 3-5 year view. If you are worried by Europe and still prefer your defensives, healthcare stocks have already had a good run and there is merit in switching out of health stocks and into utilities and telecoms – which pay a greater dividend and still offer better value.