A couple of observations from this:

1) The weighted average PE at 10.4x is materially lower than trailing~11.5x that the market is currently trading around (very rubbery figures – but it’s order of magnitude we are looking at). Taken at face value, the difference implies around 10% EPS growth for the 2012 financial year.

2) It’s notable that the materials sector is generally trading under the average while the energy sector sits on the other side. What is this saying about demand for iron ore and coal?

3) Traditionally, Australian banks have traded at a premium to their global peers and have compared favourably to other defensively oriented stocks in the local market. So while we might reasonably expect consumer staples to attract a higher multiple, the fact that utilities are being favoured to banks (relative to earnings estimates at least) is an interesting outcome in this low interest rate environment.

Back to the data grindstone…

Now, one of the truest truism’s in financial markets is the saying that not everyone can be right at the same time. The reason is that if everyone has the same opinion, and has entered into the same trade in anticipation of that opinion playing out, then no-one is left to ‘buy’ or ‘sell’ to deliver the outcome that is the expected by the consensus opinion. This is what is meant by the phrase ‘the market has priced it in’.

But just occasionally, this rule is broken – most usually because people have not acted on the strength of their convictions.

The question then is whether the universal pessimism is baked into market prices – and if so, does this prohibit consensus actually unfolding.

Let’s quickly summarise the state of play – it’s pretty easy to paint the bearish picture:

1) Global leading indicators suggest we are heading into a synchronised slowdown in economic growth with possibly a double-dip for emerging economies like Brazil and India, and reasonable odds that the US and Europe will follow. The jury remains out on China – with its property development sector likely to falter and local governments loans being hived off bank balance sheets the signs aren’t great, but it’s a command economy and can put the foot back on the accelerator in short order.

2) Australia is in a difficult position. On the one hand planned capital investment is historically huge and coal and iron ore exports remain very strong – but unless you work in the sector, or own the resource, the benefit of this plunder is questionable. The main way that the Australian economy benefits is through the tax take – and that money has already been spent. So the bulk of the Australian economy by headcount at least is struggling under the weight of excessive debt, high interest rates and rising consumer prices. This is why residential property is turning up its overhyped toes and why retail sales have dried up.

3) With equity markets having enjoyed the global re-rating of risk and now looking weak at the knees, no wonder fund managers are feeling a little queasy about the outlook.

So we get to the crux of the issue. Have portfolio managers acted on their sense of imminent doom? If we had access to some meaty data on portfolio flows, we could have a real stab at answering that (it’s something being worked on). So the simplest proxy to get a feel for the answer is by looking at relative sector performance:

What we are looking at here is the 50 day moving average for indices for Consumer Staples (XSJ), Materials (XMJ) and Financials (XXJ). If fund managers had been rotating out of risk and into defensive stocks then consumer staples would outperform – and perhaps at the margin this has been the case since the most recent wobbles began back in March. But it certainly doesn’t look like a fully fledged exit. (We’ll come back to the performance of the financials in another post.)

Another way to look at this possible sector rotation is in the following charts that look at relative performance in a longer term context:

Notably, the more defensive consumer staples sector has been outperforming both the small cap and discretionary sector since March. So this would seem to confirm the trend. But for mine if we were to really be seeing an exit from the risk trade it would show up in a flight from the resources sector – and to date, this is just not really happening.

Conclusion – while fund managers may be very pessimistic about the outlook, it does not look likely that these opinions have been ‘priced it in’. This’d be consistent with my colleague’s reply when asked, “Are portfolio managers underweight risk then?” …”I don’t think so.”

The world was already awash with rising risks but this new disaster is likely to become a seminal event in changing people’s attitudes to risk. The magnitude and breadth of the problems now facing the world’s third largest economy will see to that.

Looking at today’s price action in Australian equities, it looks like the disaster may be the catalyst to break the increasingly surreal rise in prices across the commodity complex.

We offer this market map as a reference point – as we have reviewed before (20Aug10 here), the rise of the materials sector in market weighting has only been matched by the rise of their anemic cousins in the banking system.

Given that we have sunk our anchors deep into the unending China industrialisation growth story, it will take some time for investors to adjust to the idea that the world really is a risky place and ratchet back on lofty commodity valuations accordingly. But it’s unlikely that even the Fed will be able to stem this flow.

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.

The point is that currencies matter. Consider for example the latest RBA commodity price index (original release here):

Commodity prices continued their surge higher in September – at least in US$ terms. In A$ terms, the index was actually lower month-on-month. The gap between the performance of the two has opened to a chasm that is rarely seen, or been sustained (at least for our dataset which does not go beyond 1982 and therefore does not include the commodity induced inflation of the 1970′s).

All this of course is a result of easy money – the impact of which can also been seen in the relative performance of the carry trade over the commodity trade (via AUDYEN and AUDUSD).

Prior to the Jackson Hole symposium, the carry trade was at an ebb and the commodity sensitive AUDUSD had begun to outperform. But once Bernanke reopened the sluice the rules changed. Even EURYEN has turned up – as the BOJ announced its own debasement strategy and China stepped up its support of the European periphary.

As the closest thing to a floating exchange rate, the AUD offers a rare pedigree in a world of big-arsed mutts. It makes the rationale for investing in it pretty simple. Good yield, rising commodity prices, reasonable government debt position. If you don’t like our housing market, you can always join a hedge fund or two and short our banks.

Still all good things must come to an end – not sure we are there yet, but our composite indicator for the materials sector is still not confirming the recent index strength. (It’s a composite of the Baltic Dry Index as a proxy for volume, the A$ denominated RBA Base metals index as a proxy for price and the Shanghai equities index for demand.  XMJ is the ticker for the ASX200 Materials index.)

If there was any doubt about the importance of the umbilical cord between Australia and China, the following chart mapping the relative performance of some of the world’s stockmarkets bears this out:

Australia’s economy, that was being at risk of being left behind in the sandpit in 2000, has ridden the China bull all the way to the bank. We can see the importance of the resources sector in driving this performance in a comparison of the materials to the financial sector over the same period:

The sucking sound emanating from the financial sector is profoundly disturbing.  Remember that over the same period our pension savings pool rose from ~$500bn to ~$1,500bn, and our household debt climbed from $350bn to $1,250bn currently!

One more perspective on this – consider the following chart from the ASX (here) that gives a breakdown of market capitalisation by sector in 1989 and 1999:

In the midst of the Asian crisis, admittedly as a swathe of Australia’s mining sector was being repossessed and the average return on shareholders equity was just north of zero, the market capitalisation of the sector was ~$100bn in comparison to ~$200bn for the finance sector.  Fast forward to today, and the financial sector is around $425bn versus a resources sector closer to $400bn.

With the Australian economy at best stalling, hope our surrogate continues to take their vitamins.

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.

The evidence that it’s a ‘this time it’s different’ correction?

1) Uptrend since March 2009 has been broken – Uptrends in all the major indexes have been decisively taken out. With China’s stockmarkets trading below their 200 day MA, the question is whether global markets will follow.  (see Humble Student of the Markets here)

2) Investor bullishness was at extremes – as measured by sentiment indicators from newsletters to the CBOE PutCall ratio.  A rapid switch of the greed to fear button will have longs questioning what is fair value for equities. (See DataDiary summary from 19 April here)

3) The momentum of the recovery has slowed with fading stimulus –  A lesson from the Japanese 1990′s experience was that the market goes up with government stimulus and down when the stimulus is removed. This patient needs more blood.  (see Albert Edwards Global Strategy Weekly here)

4) Fat tail political risk is in the house – Before the GFC was invented, the rules of the game were that credit risk could be sliced and diced into infinitely smaller pieces.  We assumed that legal and political risks were immaterial. They aren’t.  The immediate question is how to price ‘unhedgeable’ political risk – the unravelling of Europe, the bankruptcy of US states and even Australia’s new commodity taxes.  It’s telling that gold continues to squeeze higher – there’s precious few places to hide (see STRATFOR article “The Global Crisis of Legitimacy here).

Conclusion

This isn’t a clarion call to abandon ship.  It isn’t 2008 – with margined investors having their stock dumped into the market.  Sure there may be a carry trade or three that needs to be unwound, but buying on margin has not regained its 2007 highs.  For this reason, will be looking to add some long exposure at my estimation of fair value (see articles here and here).

In order for the markets to retest the March 2009 lows, something else needs to happen – like China imploding in a fug of property and commodity speculation.  This is a material risk – certainly the leverage in the commodities markets that has been fuelled by the rise of financial players (read article by Absolute Return Partners here) has as its single biggest assumption the ‘China industrialisation story’.  In a real sense, Australian house price euphoria is an extension of this same trade.

After reviewing the documentation again this morning, think we can expect the RSPT to hang heavy around the necks of the Australian miners for some time.  Apart from the administrative burden that the new tax will impose on all, the problem is not so much for new projects but for existing ones.  Specifically, the problem is the difference between the imputed value of a project in a company’s share price and the book value of that project on the company’s balance sheet. In short, the government will be ‘buying’ their 40% stake in the project for book value.

I don’t normally do specific stocks in this forum – but in order to flesh out the issues let’s make an exception (as long as it’s not viewed as a recommendation or in fact any form of advice).

Energy Resources Australia (ERA)

In order to get a sense of how the RSPT might operate, the following chart takes the 2009 financial result for ERA and maps how the RSPT would impact earnings per share.

To keep this as simple as possible, I have kept everything constant other than the uranium price – which enables us to see the impact of higher commodity prices.  Other interpretations of the RSPT embedded in the chart:

• Deductible expenses for RSPT included everything but shipping
• The RSPT allowance assumes a starting base of $470m (book value of PP&E) and depreciation at 36%
• Added back $41m Royalties to net profit for the calculation of income tax

The net result?  Assuming all else constant, EPS falls to $1.25 versus the $1.42 recorded for 2009 – ERA would have paid a tax bill around ~$190m versus actual tax of $115m.

Importantly, in relation to the government’s concept of ‘buying a 40% stake’, I’ve assumed that ERA has $470m of ‘undepreciated tangible capital expenditure’.  That’s ~$2.50 per share versus a current share price of ~$14.50. Hmm – you get the point about the difference between book value and market value.

Conclusion

This is clearly over-simplified as a model.  And it does not take into account the tax benefits that accrue if the project falls into a loss making situation – a benefit not offered under the current state based royalty system.  The objective was to get a sense of the way the RSPT works on an existing project.

As to it’s impact on ERA, it depends on your assumptions about the future uranium price.  Clearly, the higher you assume uranium prices will climb, the greater the impact.  But even then it’s not that simple:

• ERA’s Ranger mine is close to the end of its current life – which is expected to fall within the start of the RSPT regime in 2012
• Its heap leach project to extract uranium from stockpiles is yet to commence construction.  Whether it qualifies as a pre-RSPT project is unclear.
• The Ranger’s Deep expansion is also subject to feasibility studies – same question is this pre-RSPT.
• Jabiluka remains in mothballs – presumably to be classed as a new project should mining commence.
• And then there are some good reasons to doubt the strength of uranium prices notwithstanding China’s building spree.  The secondary market in dismantled nuclear weapons comes to mind given Obama’s recent wins in this area.

One final note – it’s been instructive to see the response to the RSPT being played out in the media.  Miner’s have predictably cried foul.  Most media commentators haven’t read past the headline.  And advisor’s have been ferreting around trying to make sense of the word “super” (look at this piece from Allens Arthur Robinson – not sure which documents they have been smoking). Most interesting of all – what is the government’s PR strategy on this?  I’m a Machiavellian at heart and I reckon this one would be a cracker to to get inside.