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.

This chart tracks the monthly average PE ratio using current EPS and a 10 year average EPS for the All Ordinaries. (Note the EPS has been imputed from historical PE data – order of magnitude it should be okay, but wouldn’t take individual data points as gospel.)

Some observations:

• As I have not inflation adjusted the numbers, the 10yr PE ratio will generally be higher than the current PE.
• It’s notable that throughout the noughties, the 10yr PE ratio diverged from current PE as earnings rose rapidly across the period. We’d need to do more digging to differentiate the effect of rising leverage in the domestic economy and the stellar earnings performance of our materials sector – suffice to say, EPS growth was a result of both.
• The March lows of last year were historically significant across the period surveyed (but fell short of the 70′s experience – not shown).
• The long term average for current PE is 13.7x and the average 10yr PE is 21.5x.

Expected earnings growth is clearly a fundamental factor in driving the PE ratio at any given time. So to try and put the PE ratios in context following is a chart of year on year changes in EPS:

We can clearly see the consistent earnings growth that was a hallmark of the low inflation, easy credit noughties. Perhaps of more relevance to our current environment is the post 1987 boom and bust cycle as credit conditions were first eased and then reigned in. The relative stagnation in earnings ultimately lead to 10yr PE dropping through the current PE in the early nineties. There is a lesson in there for today’s markets.

As a cross reference, the following chart maps the earnings yield and dividend yield on the All Ordinaries against the 10 year government bond rate:

Again the noughties reveal themselves as a low volatility and low interest rate period – no wonder it was so easy to venture up the risk curve. It’s interesting that prior to this, 10 year bonds were generally higher yielding than their equity counterparts.  This isn’t a long enough data set to say which relationship is the better guide – for example I understand that in the PE’s were also higher than bond rates in the 70′s. Still, with the globe heading into a period where higher long term rates are likely, this isn’t prima facie equity friendly.

Additionally, we can expect dividends to be increasingly important as baby boomers move into full-blown retirement. In this respect, dividend yields may exert a stronger influence in determining valuations across the next decade.

Finally, to bring this into a narrower focus, following is a chart of the PE ratio for the ASX200 (based on 12 month trailing underlying profits) against the 10-year government bond rate. (Note this is a different data set – taken from the RBA’s Bulletin – the tighter earnings yield probably reflects the larger market cap status of the companies in the sample.)

In this wanted to highlight how consensus forecasts are pitching earnings for 2010 and 2011.  Assuming analysts have pretty good clarity on 2010 EPS from here, then the big question mark hangs over the ~20% rise in 2011.

Conclusions:
1) Absent another shock, the market could well push higher from here – it’s all about risk appetite after all.  With the normalisation of earnings (ie. we have passed through the property and credit write-offs), the PE on 2011 consensus forecasts is around 14.0x with the ASX200 at it’s current level of 4930. The analysts that are pointing to 5500 by the end of the year would suggest that at a PE of 15.6x this represents fair value against an average for the last decade of about the same.

2) However, I’m not a buyer at these levels.  Fair value looks more like a PE multiple of 12x in the context of the above charts – which on the same 2011 consensus forecasts would have the ASX200 at 4250.  Why?

• We are in a global deleveraging cycle.  It may not have occurred to Australian householders yet, but we are an anamoly in world markets.  We cannot reasonably expect the steady growth in earnings of the noughties to be repeated.  More likely the business cycle will be akin to the post 87 crash, with earnings and valuations responding to changes in credit conditions as central banks alternate between looser and tighter credit conditions. This will cap earnings growth and PE multiples for some time.
• The consensus forecasts for 2011 assume a 20% uplift in earnings from 2010. While perhaps reasonable on the basis of a continued recovery led by China’s demand for dirt, there are considerable risks to this scenario – a US/China trade war, sovereign defaults in Europe, a property correction in Australia etc. For these reasons, it is prudent to discount the probability of these earnings being achieved.  I’ve done this through applying a lower PE ratio.
• To put the PE ratio in context, the average PE ratio for the All Ords since 1974 is 13.7x versus that of the last decade of 15.3x. You pick which is the more appropriate long run average to apply to earnings.
• And finally, for the aging demographic an implied dividend yield between 5% and 6% would compare reasonably well to a bond yields.

Note to self – Big picture valuation of markets is an inexact exercise.  That’s okay, if you don’t expect too much from it.  The intention is not to divine the next 10 point move but rather to build a framework within which we can then make investment decisions – whether it’s asset allocation or stock selection. So when people argue the to’s and fro’s of using trailing earnings versus forecast earnings, accept the arguments as valid.  The point is that each method has its flaws and advantages.  The best bet is to use them all if you have the resources.

]]> http://www.datadiary.com.au/2010/03/24/what-is-fair-value-for-australian-equities/feed/ 5 http://www.datadiary.com.au/2010/03/17/the-return-of-the-teuton/ http://www.datadiary.com.au/2010/03/17/the-return-of-the-teuton/#comments Wed, 17 Mar 2010 01:28:40 +0000 Rohan Clarke http://www.datadiary.com.au/?p=1765 Technical views with Iron Cuticles

Some call me a teutonic throwback to the Brother’s Grimm – let them eat iron.  Of course, I’ve been wrong before, most recently about that midnight burrito, and probably will be again.  However, I’m not a perma bear, just seems that way given a bearish bias that has permeated my chart reading since the S&P broke out in July last year.

So when I say today that the January sell-off has left some unfinished business – I will forgive you for a suppressed giggle.  Be that as it may the weekly chart of XJO is suggesting that we are in a corrective phase and that the recent dip and charge has set up a deeper retracement in the weeks to come – I’d be happy for a test of channel support I’ve pencilled in.

Price momentum has been waning for eons – with RSI confirming the trend since peaking in October last year.  The balance of probabilities has MACD being rejected off its current attempt to cross.  Certainly the January (monthly) key reversal still stands, though the subsequent recovery from the lows was impressive.

To mine, the near term trade is a short.  But I’m willing to concede that a break of January’s high would change the picture fundamentally. I’d expect a move through 5000 to be sharp and dramatic if the market can find the stamina to push on.

A trend reversal in the monthly (higher high and close below the previous months range) has good form as an leading indicator of market direction.  The conclusion – keep out of the carrot patch unless you are particularly fleet of paw.

Back to the trusty CBOE put call ratio:

The downtrend in the ratio has been cleanly severed.  It will need to push through 0.80 before I consider some longs…

The Australian equities market is at a crossroads – trading in a ever narrower range and refusing to capitulate (as I’d been expecting right about now). Unfortunately, arguments can be made for both another fling higher and a more substantial correction.

The bulls can simply point to the fact that we remain in an uptrend.  The recent consolidation suggests a break of ~4800 would target a swift move to 5100-5200.  Certainly the slow stochastics have retraced to a point that would support the case that this was wave 4 and the final push higher is in the wings.

For a deeper test, need to break the most recent low around 4600, which would take us through the March uptrend and give rise to a great deal of hand wringing and flatulence.  Supporting this view is the crossover of the weekly MACD and the fact that momentum continues to trend lower and has broken to new lows for the move since March.

Interesting that this same pattern is being mapped out in the AUDUSD – except that here the Aussie has broken its March uptrend line.

The carry trade is wavering.  Further strength in the USD could lead to unwinding of risk positions across the spectrum.  For the moment, commodities are hanging tough – consider the chart of the ASX200 materials sector (XMJ):

If we are to have a move lower, this sector needs to join in cause, as with weakness in the financial’s continuing, it has been the metals sector holding our market up.  In fact, could be argued that it will be financials that underwrite a surge higher, as they may be due for a bounce as they approach various moving averages and that damned nicketty March uptrend:

Staples, consumer discretionary and property are also all looking weak – so on balance still favour the downside from here which is why I remain small short.  Just that with Christmas upon us, we have turkeys to stuff and ducks to confit – lack of interest might just dictate that this market goes absolutely nowhere.

You can (hopefully) see the trade.  We either break through the resistance around 4810 – with reasonable odds that we can then go on to make new highs.  Or we break lower – and test 4500 tout suite.  It’ll come as no surprise I’m betting that the gods of the underworld will prevail.  The divergences in MACD and RSI continue and even accelerated in the latest price action.  Momentum made a new low on the recent dip – and while it recovered strongly, failed to make a new high (okay – this may be clutching at straws – the point is momentum has progressively waned as the rally has aged).

On a wave count basis, we are either finishing up (ii) of a larger 3rd wave down or we are in a new bull market and we have completed a first pulse higher in a 5th wave (and have a dip into a (ii) which could take us to 4600 in any event).  I’m figuring it’s the former – and that it has all but met it’s upside targets and, from a day count perspective, by Friday it will be ripe and smelly.

The conclusion?  The risk/reward favours the short from here (4800 v 4500 in round numbers)…with volatility pushing the low 20′s and a reasonably brief period for the theory to be tested one way or another…all adds up to loading up over the next couple of days.