The Market: Black Holes Or Diamonds?

Sydney, July 18, 2008 (ABN Newswire) - A more modest, less than 1% recovery yesterday for our market after Wall street's exuberant jump tells us that we in Australia are a bit more circumspect about the outlook.

US investors seem desperate in comparison to pile into shares: the battered banks and financial stocks had their biggest rebound in 17 years and yet no one wanted to own them the day before. 

All this on a better than expected poor result from Well Fargo, and then a better than expected poor result from JP Morgan? Don't think so.

US banks are retrenching: Citigroup is slicing off bits and selling them (as is GE, the second biggest company in the US). Merrill Lynch is another selling off its best assets to keep its nose above the waterline.

Other banks are doing the same; all are cutting lending; securitisation is dead, fee income is weak and profits rare in some parts of their businesses. That is not the way to generate earnings, let alone grow earnings, which drives share prices higher.

It is a well-run bank, but its not the saviour of the US banking industry. 

An end to the relentless fall in US housing prices gold that key and we will get another update next week on the state of the sector with more information on the state of prices and home sales.

Here we have the June quarter Consumer Price Index to confront: it will be high; above 1% by most estimates for the quarter, but the Reserve Bank has conditioned us to look past that out into 2009-10 when it seems inflation slowing. 

So if there's a spate of 'rate rise looms' stories and comments from the more exciteable in the market commentary teams, ignore them.

More earnings from Listed Investment Companies are expected in the coming week and should confirm that its been a rough half for them: and the first significant result is due from GUD Holdings next Thursday. 

It sells the Sunbeam brand of homewares. They are mostly imported, so GUD has benefited from the stronger dollar, but the retail sector has been doing it tough and the company's comments on that sector and Sunbeam will help us.

The BHP Billiton production report will be a major influence on the market and possibly the future direction of that bid for Rio Tinto. 

The bloom is going off the resource sector as China slows and other major economies slump (See separate story). In times gone by that usually saw big investors and their friends rotate into either banks and financials, or consumer staples.

Bank and financial stocks have had two solid days, but they are still twitchy and a series of poor reports in the US could send them lower.

But with the market off 28% from its peak last November 1, and most of that fall happening in 2008, and especially since Mid-May, some brokers and analysts are wondering if the bottom of the trough is nigh.

JPMorgan told clients yesterday that the ASX 200 Index is nearing its bottom.

"We do not have much further to fall,'' the JPMorgan strategists wrote in a client note. "With the market now close to what we think is a recession multiple, the environment is becoming more conducive to looking for contrarian names.''

" Our model of the Industrials (non-Resources) PE indicates that stocks are trading about 10% cheap after allowing for a reasonable degree of earnings risk," JPMorgan said.

"The problem with a PE approach is that the market may be saying something about longer-term earnings prospects as well as about risks in 2008-09. The background for corporate profitability over the next 5 years looks a lot less benign than the conditions which drove margins to record highs over the 1993-2007 expansion. •

"The Industrials are not so cheap that value alone will make them outperform Resources stocks if the commodity cycle holds up. 

"Neither do Resources stocks look expensive on our PE model. The reason to tilt away from commodity exposure is a negative one: the weakness of global growth, including emerging economies, is undermining the demand story.

"However consensus forecasts for Industrials now assume 10% earnings growth in the year to June 2009 (this has actually crept higher as analysts have shaded 2008 numbers).

"Our view is that 2009 is likely to see a 5-10% decline in Industrials earnings; if we are right the PE would appear to be about 10% cheap.

"This is encouraging, but some discount is warranted.

"For one thing there is more downside risk to earnings next year than there is upside risk.

"Secondly, this model uses relationships that held good during a bull market.

"The risk of applying them now is that equities have become more risky on a sustained basis and therefore will trade more cheaply relative to bonds than they have in the past."

So from what JP Morgan said, there's some value there, but there are still downside risks for next year.

Australian and international equity markets are offering extraordinary long-term investment value according to Russell Investments' July-quarter Markets Barometer.
Russell, while warning of likely further volatility in the near future, said investors can currently maximise returns if they take advantage of the "opportunity to buy future growth and profits at significantly discounted prices".

According to Russell, the combined price/earnings ratio (PE) of developed global equity markets is now trading near 18-year lows at 12.5 times.

Concurrently the consensus earning per share (EPS) forecast, as calculated by international equity analysts, is for growth of some 12 per cent over the proceeding 12 months.

Meanwhile the Australian equity market's one-year forward PE is sitting at around 12 times - significantly lower for selected sectors and blue chips - which Russell points out is less than when the circa 2002-07 bull market started its stellar run.

The Australian equities market, as gauged by the S&P/ASX300, has slid some 18 per cent over the first half of calendar 2008, compared with the US-based S&P 500 falling by around 13 per cent and the MSCI World ex US index declining 12 per cent.

Arguably, the Australian equities market is in better shape than many international counterparts, particularly the US.

Russell senior investment manager Andrew Pease said "in the long run, local equities should also move higher by the end of the year but are likely to lag global share market returns.

"Investors with a long-term investment outlook, beyond the next six months, should take note of the low PE ratios on offer for global equities, combined with resilient profit expectations

In their latest Market Barometer, the group says that investors with longer time horizons should recognise the value currently on offer. I

The report found that while more volatility seems likely in the near future, investors with long-term investment horizons can now maximise returns and take advantage of discounted prices.

Global developed equity markets continue to show exceptional value, according to the July Barometer, with the forward price to earning (P/E) ratio hovering near 18-year lows at 12.5 times. Stockbroking analysts forecast that earnings-per-share (EPS) for global equities will grow by 12 per cent over the next 12 months.

Meanwhile, Australian shares continue to face more headwinds than their global counterparts. 

Russell says that over the first half of the year, the S&P/ASX 300 has fallen 18% compared to the 13% in the S&P500 and the 12% fall in the MCSI World ex US share price index.

"Despite the local market facing market volatility in the near future, the long-term valuation characteristics are sound. The one-year forward PE ratio, at 12 times for local equities is lower than when the bull market kicked off at the end of 2002."

Senior Investment Strategist at Russell Investments and author of the Barometer, Andrew Pease said: "Investors should step back now and ask the two fundamental questions: "what is the long-term outlook for profits?" and "what price am I paying for these profits?", he said in the report's statement.

"Investors with a long term investment outlook beyond the next 6 months should take note of the low PE ratios on offer for global equities combined with resilient profit expectations. 

"In the long-run local equities should also move higher by the end of the year but are likely to lag global share-market returns", he said.

:Headline inflation rates have soared around the globe recently reaching 5.0% per cent in the United States, 3.7% in Europe, 3.8% per cent in the United Kingdom and 4.2% per cent in Australia.

However unlike the 1970s, wages are not surging in response to the higher cost of living. 

In the rest of the world, inflation is rising mainly because of energy costs and when these are taken out of the equation, inflation is still low. However, by contrast, Australia's core inflation is rising at the same rate as headline inflation.

"Australia's inflation problems are more widespread than the rest of the world. Australia's economy has hit capacity limits producing 'demand-pull' in addition to 'cost-push' inflation pressures and the Reserve Back faces a difficult balancing act over the remainder of 2008." Mr Pease said.

"Australian fixed interest is beginning to show signs of good value.

"The 10-year government bond yield is currently at 6.5 per cent and looks more attractive than several years ago.

"Non-government securities make up close to half of the UBS Composite Bond Index and the overall yield on the index is close to 8%.

"From 2002 to 2007 when Australian shares were returning 21% a year, the UBS Composite Bond Index delivered just 4.5% per annum making fixed interest an unloved asset class. 

"With higher yields and the prospects for capital gains if bond yields decline as the economy slows, fixed interest now looks more attractive than for many years according to Mr Pease.

"The LPT sector has moved from being dangerously overvalued at the beginning of 2007 to more reasonable valuation levels. 

"Over the June quarter, LPTs lost another 20% to take the total fall since February 2007 to 46%. The LPT sector is now on a forward PE ratio of 11 times, compared with the PE ratio for the equity market of just over 12 times.

"Small-caps have underperformed large caps by 4 per cent over the past year. Small-caps are trading at a PE ratio discount to large caps for the first time since late 2005. The forward PE ratio for the ASX100, providing no strong signal about relative performance prospects."

"The Australian dollar has been stuck in the 94 – 97 cents for the past couple of months, threatening on occasion to push through to parity.

"The main factor behind the Australian dollar strength over the past five years has been US dollar weakness rather than commodity prices or interest rate differentials.

" It would be hard to imagine a more bullish A$ environment than that of the past few months with widening interest rate differentials, soaring commodity prices and entrenched US economic pessimism, yet the A$ has been range bound. This hints that the A$ upswing may be running out of steam."

Mr Pease said it was "difficult to be overly pessimistic about the local market.

"Valuations, although high relative to other markets, look attractive in absolute terms. 

"Compulsory superannuation contributions are likely to pour up to $30 billion into the equity market this year and the Future Fund is still building up local equity market exposure in its $60 billion plus portfolio." 


 

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