In this model there are three moving parts, going through these we can start to see how the conflicts emerge and where the opportunity to create an alternative point of view may reside.

So we have Earnings – the elemental building blocks of any investment. Into this balloon is grouped everything that drives the fundamental earnings of individual companies – it’s a rich interplay between interest rates, inflation, demographics, innovation, legal process, tax treatments etc. The net result is a single number that defines the return on any investment. Needless to say, when we extrapolate this number into the future, the resulting ‘forecast’ earnings can be plagued with uncertainty – this is a big part of the risk bit of any investment.

Flows determine arguably the cleanest dataset in the capitalist world – price. Through the process of buying and selling an asset, good or service, a clearing price is set. And while prices can be distorted by fair means or foul, they can also be directly measured, compared and analysed. Price is the clearest expression of the herd as regards expectations for Earnings – so while interpretation of movements in flows and prices may be subjective, the underlying data is not.

The net outcome of flows is Valuation. It is the amount that the market is prepared to pay for the expected earnings on an investment – and is a result of the demand and supply of that investment on the market.  Note that unlike earnings or flows, valuation is a derived, it is not directly observable as a distinct element in its own right. The implied valuation of an investment may change according to movements in its price but it is uncertain as to whether this is a result of changes in investor’s risk preferences, earnings expectations or some completely unrelated factor.

Circling back, how does this help addressing conflicts of interest in finance?  Taking a leaf out of Dan’s book, we can use the model to take the first step and recognise what the conflict looks like. Then once we understand where the conflict emanates from we can look at alternatives that do not suffer from the essential conflicts or may help to address them.

So what does the conflict look like? There are a essentially two issues here:

1) Access to information – As we have seen, in order for investors to be derive informed views about earnings expectations and how the market is pricing these, they must have easy access to the information. The accessibility to information varies by country and market – for example in the US, information is relatively more mobile than in the UK or Australia. In these latter jurisdictions, some market platforms are conflicted by a profit motive which leads to asymmetric distribution of information.

2) Alignment of interests - The majority of people do not have the time nor expertise to directly manage their on-market investments – they require assistance. The conflict arises from within that the industry structure that has grown to provide this expertise. The issue is one of alignment with the end investor.

Typically, an analysis of the investment industry conflict will look to the remuneration structure of financial planners – but the issue is much broader than that. A quick example from my own experience might illustrate (ie. if I’m pointing a finger at anyone, it is at myself).

Let’s take a look at valuation. An investment banker when structuring a new investment offering looks to relative prices to determine valuations. The thing that really matters is whether this investment compares favourably to the rest of the market. Any such valuation is based on my expectations for earnings and how the market will price those earnings into the future. Remember I get paid to sell you this investment, not to make sure it performs according to my forecasts.

Now we could similarly look at how funds management is a relative business, or how independent research companies are compromised by their remuneration structures, the point is that there are few mechanisms that promote the alignment of participants with the interests of investors.

So how can information technologies assist?  In short, through promoting accountability and by enabling the establishment of a truly aligned research and analysis model.

Make information more freely available

In an age where data is mobile at negligible cost, there should be no material impediment to allowing market data to move freely. We should be able to analyse flows as well as price and integrate analysis of economic data and other variables with relative ease.

In short, there is a public good to ensuring information is made widely available to all. It is one way that artificial distortions in price can be addressed. The extraction of monopoly profits for ‘ownership’ of such market information is clear evidence of undue influence by established interests. This is the simplest conflict of interest that can be addressed.

Encourage people to become more independent

Communication technologies are leading to a rapid evolution in the approach to education through online resources. The increasing sophistication of video tutorials and interactive real-world examples opens the way for real alternatives to be developed that will enable those that have the desire to increase their expertise when it comes to the finance sector. This is another way of promoting greater accountability.

Encourage truly independent analysis

Cheaper and more efficient communication can also assist by establishing alternatives for accessing research and analysis from within the current investment industry structure. Social media technologies offer the scale for more ‘aligned’ solutions to become viable. For example, there is the opportunity to establish an alternative research and analysis model that is not subject to conflicts because it is not reliant on income from those that sell goods and services for its survival. For those investors that require assistance, there is at least one truly independent source of research and analysis.

Conclusion

The emergence of product-comparison and swarm-purchasing-power sites is but the start of a move towards shifting more power to the consumer. As the technological blow torch gets applied to more information based industries, the likelihood is that those that rely on the current industry structure to protect their franchises will be challenged. I’m hoping the initiative we are working on will be part of the new landscape…

By way of explanation, a lower number on the value ranking generally reflects a lower market valuation for that sector’s earnings. The ranking seeks to take into account the variations that occur within a given sector over time and across sectors – the question being ‘is the sector relatively cheap relative to it’s own historical performance and relative to other sectors’. The earnings outlook again takes a forced ranking approach where a higher number on the earnings outlook reflects a more favourable outlook for earnings for that sector relative to others.

The point of the exercise is to insert a little big picture analysis into our portfolio management. While it is clearly broad brush in its approach, it serves as a cross reference against existing positions and to potentially find new areas of interest. Given my value orientation, the sectors in green generally attract immediate interest. However, the prospect of buying into sectors in the red zone has appeal, where there is a strong argument that the stock or sector is still undervalued relative to its growth outlook. Note too that this approach says very little about individual stocks – it wouldn’t be a very macro if it did.

The following tables list the data for individual sectors.

From the market low in 1884, the market added around 5% per annum – the blue line above illustrates what straight line growth of 5.2% per annum would have looked like. (For clarity, this does not include dividends.)

A couple observations from this chart:

1) The relative step up in the market from the mid-70′s onwards neatly coincides with increasing leverage in the Australian economy. With the baby boomers reaching asset liquidation age, it’s reasonable to suppose that we are approaching the more difficult part of the market valuation cycle.

2) It takes a long time to work off excesses (see an earlier article here), whether by inflation, saving or innovation – something like 13 – 15 years seems about the norm. On the assumption that we are in a bear market cycle, that started in 2007, we might expect the market then to regain its recent peak around 2020. Still, one could argue that this is view of the world is redundant if we have simply become a vassal of China.

Zooming in a little to look at how the market performed over a number of cycles, the following chart starts from the market peak in 1970. (Note that the blue trend line in the chart is the exact same one that we saw in the earlier chart – that 5.2% per annum growth since 1884.):

On the assumption that this ~5% growth in the market is the mean that we keep reverting to, then this chart seems to confirm that fair value might see the market back at its 2007 peak around 2020.

Perhaps its not so remarkable that the Australian market appears to have a speed limiter set at around 5% per annum.  That roughly equates to our long term growth in GDP amplified by corporate leverage on earnings.

And as if to further reinforce the point, the following chart maps the growth rate peak to peak and then low to low between 1987 and 2007. Once again it seems that the an annual growth rate of around 5% seems about right for the Australian market.  The yellow trend line in the middle takes the mid-point of the 1987 high to low and extrapolates growth forward at our magic 5.2%.

Think these trend lines pretty neatly capture reasonable expectations for the range for the market that we can expect for the next few years. With peak debt likely behind us, think we can expect the squiggles to be contained between 3000 and 5500 for a year or five yet.

So herewith is the log chart of the All Ordinaries price history since 1875:

Now you might argue about the choice of market cycles – I admit to liking the symmetry of ~27 year bull markets against ~13 year bear cycles.  But the point remains that with 2007 ushering in the end of the global debt party it looks likely that we’ll be trading in the bear zone for some years to come.

]]> http://www.datadiary.com.au/2010/08/17/australian-equities-in-the-bear-zone/feed/ 1 http://www.datadiary.com.au/2010/05/27/macquarie-with-some-science-behind-a-12-3x-pe-ratio/ http://www.datadiary.com.au/2010/05/27/macquarie-with-some-science-behind-a-12-3x-pe-ratio/#comments Thu, 27 May 2010 04:43:12 +0000 Rohan Clarke http://www.datadiary.com.au/?p=2634 Sometime back we suggested that the PE ratio for the equities market was likely to fall relative to recent decades.  Based on some spurious pointing at historical charts, we came up with an expectation that the average PE ratio might be more like 12x (see here).  On our numbers that suggested ‘fair value’ was around 4250.

Macquarie in strategy piece released on 25 May 10 have come to a similar conclusion.  Their analysis is based on the premise that we have moved into a period where cycles are likely to be shorter and sharper.  This means growth on average will be lower – they assume GDP growth will be more like 2.9% than the recent 3.5% per annum:

And that this will lead to a contraction in the average 1-year forward PE to around 12.3x:

But more than that, the volatility in earnings arising from these shorter cycles also leads to wider trading around this perceived fair value PE ratio.

All makes sense to me.  Just that my chart pointing was quicker and has fewer assumptions.

Conclusion

That the market found support around 4200 is consistent with our thinking that it represents reasonable long term value.  With our risk indicators having started to calm with the consolidation in the markets, expect equities to trade higher in the short term as investors cling to recent history with respect to valuations and earnings.

On a wider angle, it’s hard to believe that we have found the bottom on this wash-out.  Until the US or Chinese governments step into the breach, I’m expecting the downtrend to prevail, and I suspect that they will keep their powder dry until the market has stretched itself to the point of exhaustion.

It’s an incestuous world we live in these days, so in keeping with that thought, following is his chart of the trading of the Australian ETF against the Canadian ETF:

The obvious conclusion is that based on the last decade, the Aussie market is treading into relative value territory.

It’s reasonable to argue that the Super Resource Profits Tax has been an important catalyst for the recent price action.  The miners (and their shareholders) must be hating the idea that this tax might be infectious.

Australian banks trade at a premium to their international peers

Our banks are trading expensive relative to their global peers (like this simple analysis from Citibank – via Alphaville here).  There are many valid arguments put forward to support this – such as “Australia has…”:

• A stable (and consolidating) banking oligopoly
• A mortgage market structure that has historically lead to low default rates
• Recent population growth at ~2.5% per annum
• An economy leveraged to the industrialisation of China and India

On the other hand, an oft cited risk to our privileged position is that as a capital importer we are reliant on the good graces of our creditors – something that becomes more fragile with national borders getting firmer by the day.  How are our banks exposed to the rising cost of risk?

A snapshot of the Australian majors balance sheets

It’s a big question, and not one that can be answered in a short(ish) note.  Just want to focus on the most obvious aspect of bank funding in this respect – the wholesale debt market.  Following is a quick summary of the four majors balance sheets:

In short, ANZ has 20% of its loan book funded in the wholesale markets (“Bonds”), CBA 22%, NAB 35% and WBC 33%.  That’s not insignificant in itself.  Whether ‘deposits’ are directly exposed to international capital flows is something for further investigation – at the very least, rising risk premiums will flow through to deposit rates eventually.  But let’s leave deposits for another day.

How much of this wholesale funding comes from international capital flows?

According to the RBA, Australian financial institutions have ~$320bn in offshore funding – something approaching 70% of their wholesale long term funding requirements.  We can get a glimpse of the make-up of this across the market via the government guaranteed funding scheme.  At it’s closure in March this year, there was approximately ~$140bn in long-term funding guaranteed.  A breakdown of this guaranteed debt by borrower is:

And then looking at the maturity profile of the guaranteed debt:

So what does this tell us about our bank’s international funding requirements?  Not a whole lot other than it looks like going into the end of calender year 2011, the banking sector will be hoping for a favourable pricing environment for the refinancing of a reasonable lump of debt (~$60bn) across 2012.

Wholesale funding requirements of a major trading bank

Absent the bandwidth to analyse each of the majors individually, here is a summary of CBA’s wholesale funding requirements:

CBA has a reasonable slab of debt that needs to be refinanced over the next two years – $26bn represents ~25% of its total wholesale funding requirement.  Note too that amount is five times the volume of guaranteed debt.  If we were to extrapolate that to the rest of the sector, the total wholesale funding requirement looks more like $300bn (of course, given the sample size it’s a highly dubious extrapolation – but point taken on it being significantly bigger than $60bn).

But does this mean the banking sector is unduly exposed to international capital markets?

Well using CBA as an example, the simple answer would be no.  At just over 5% of the aggregate of its loans outstanding – the wholesale refinancing requirement of CBA for the next 2 years is manageable.  The impact of higher funding costs would certainly impact margins – but it is not a game-changing event in isolation.  (Note what applies to CBA may not apply for others…in the interests of expediency I’m using CBA as a litmus test.)

But cost of funds will rise

The point is that rising risk premiums in the international capital markets will flow through domestically.  If international capital costs are higher, local deposit rates will ultimately follow.  Bank margins will be squeezed.

Conclusion

Does this all mean Australian banks are unduly exposed to international capital markets?  Based on the toe in the water, the answer is no (unless ‘deposits’ are hiding some international capital flows).  The wholesale funding requirement looks like it is manageable even under stressed conditions.

However, the global cost of risk is on the rise.  Not necessarily due to inflation pushing rates up (the deflation/inflation debate is one that is yet to be won) but simply because risk is being repriced.  No amount of money printing will solve this – it, in fact, reinforces the trend.  This is the reason why Australian banks have been forced to ratchet up loan rates ahead of official rate rises.  It is a trend that has yet to run its course.  And it alone is sufficient to step warily around bank earning forecasts for some time to come.

Epilogue – Expect the government guarantee scheme to be reintroduced

The scheme commenced on 28 November 2008 and closed to new liabilities on 31st March – existing commitments will remain guaranteed until they mature (subject to the requisite fee being paid).

Under the scheme, Australian ADI’s (and qualifying others) got deposits and funding guaranteed by the Commonwealth Government for up to 5 years. A fee of between 70, 100, or 150 bps per annum is payable on the guaranteed amounts subject to the rating of the entity receiving the guarantee (respectively AAA to AA-, A+ to A-, BBB+ or below and unrated).

This has been a good little earner for the government – it booked $103m in February ($111m in January) and $1.3bn to date under the scheme. The fee structure is sensitive to the exchange rate on foreign currency denominated borrowings – that is, the fee is paid on the face value of the foreign currency amount borrowed (AUD down, fees up).

Given the perceived cost of guaranteeing bank debt is low, while the revenue is large enough to be meaningful, I think we can expect the government will be credit wrapping bank debt again in the future – regardless of whether it distorts Australia’s capital markets.

But as to why a PE of 12x looks both likely and a good entry level – consider the following chart:

Post the 1987 crash the market flirted with a PE of 12 on a number of occasions – each time bouncing from that level. Given where we are in the ‘recovery’ both domestically and internationally, and the ever stretching rubber band in risk appetite, the odds of a clean-out are pretty good. Just a question then of where your risk tolerance kicks in…