REPEAT Rudi’s View: Value Is Not The Only Factor

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FNArena editor Rudi Filapek-Vandyck shares his views and insights with subscribers on irregular basis. Sometimes these views are shared with non-paying members at FNArena and readers elsewhere. This is one such occasion. The story below was originally published on Thursday last week. It has now been repeated to make it available to a wider audience.

By Rudi Filapek-Vandyck, Editor FNArena

Whether it be another example of “cosmic energy” or not, earlier this week I was contemplating what to include in my Rudi's View story today and I instantaneously thought about the market strategists at Deutsche Bank.

Those readers who keep track of the various market projections by stockbrokers in Australia might remember Deutsche Bank strategists Tony Brennan and Tim Baker positioned themselves at the top of market expectations earlier this year by forecasting the ASX200 would reach 6000 by year end.

As the market is now back at around 4400-something, following two failed attempts to break above 5000 in January and in April, my first thought was whether Brennan and Baker would still feel comfortable with that prediction.

After all, it's okay to stick one's neck out and put a number on the table, but what if the global context changes in the meantime?

The reason why I referred to the cosmic energy theme in my opening sentence is because when I skimmed through various broker research reports this morning, I immediately noted Deutsche Bank had released an update on its market projections.

We all know why: those earlier projections have been pared back. But, and this is probably as important, not by as much as one would have thought.

Deutsche Bank remains firmly on the side of the market optimists, with both strategists arguing the market is taking a very bearish view on earnings growth next year, with share prices falling to levels implying very low growth for fiscal 2011.

This then leads to the inevitable conclusion that the recent falls in global share markets have opened up value-opportunities.

Note the Deutsche Bank strategists do not dismiss the problems in Europe, nor the uncertainties in China, nor the slow recovery in the US, not even the fact that the Australian economy too appears to be slowing.

It's just that they are of the view that at some point all those factors have been priced in, and right now, that seems to be the case.

Taking into account that all of the above mentioned factors will cause some downgrades to present earnings forecasts -in the order of 5% for FY11 and 5% for FY12- Deutsche Bank believes the ASX200 should be at 5586 by year end.

In other words, the second half of the year should see a gain of approximately 25%, dividend pay-outs not included.

If you think that is a bit rich given the present state of investor sentiment, then consider that the official target for the ASX200 has been set at 5750. In other words, Brennan and Baker don't believe earnings expectations will come down by as much as 5% for each of the next two fiscal years.

(The official target, by the way, implies a gain of nearly 30%, final dividends not included).

As per always, the devil is in the detail.

The Deutsche Bank projections for the Australian share market imply a normalisation of share markets and investor sentiment in the months ahead, so that the average Price-Earnings multiple (PE) for Australia's top 200 listed companies will be allowed to trend back to 14; the market's long term average.

Were we to take a slightly less bullish approach, and assume a PE ratio of 13 instead (still including 5% cuts to FY11 and FY12 forecasts), then the ASX200 is only projected to reach fair value at 5187 by year-end. Add the fact that Deutsche Bank's earnings estimates are a bit more bullish than what we have calculated as consensus estimates here at FNArena and we can easily slice off another 100 points or so.

Of course, we can play around with these numbers until the cows come home, but at the end of the day the market's value and direction will be determined by what happens with the world economy between now and next year.

While I'd be inclined to agree with all those experts that the Australian share market looks relatively cheap below 4500, I also have a few points to add:

– The current trend in global growth expectations is negative. Most experts might stoically stick to their earlier calculations and projections, but on an individual basis there is no discussion possible: growth expectations for Europe, for the UK, for China and for Australia are trending down. Not in a big way, as expectations for Europe and the UK were relatively low in the first place, but down nevertheless.

– The Big Question among all of this is whether expectations for the US economy can hold up. It is only fair to say this remains a Big Question at this stage and we will all have to find out whether this will prove to be the case. The US housing market, mortgage stress and unemployment, to name but three factors, appear wobbly enough to at least remain not too convinced about what is likely to follow next.

– China, India and other economies in Asia might be holding up well, the US and Europe remain the Big Guns on a global scale, especially if either or one of both were to slump into negative growth again. Europe is simply not looking good, the US is equally looking towards a slowing in momentum. At this point in time you'd either have to be a brave man or a fool if you dared to call exactly where both economies will be at in six months' time.

– Never underestimate the fact that an uptrend tends to cover up the negative, but that a negative trend exposes weaknesses and can bring out the worst. Nobody ever mentioned Dubai or Greece when economies were running hot, but from the moment the downturn kicked in the pressure kept building until both became the subject of global news headlines. The same principle applies to companies, just ask Downer EDI ((DOW)).

– While earnings expectations have been in decline since April, overall erosion for FY11 and FY12 estimates has remained benign thus far. This does not take away the fact that this trend too is now negative and that more of the same should be expected. Most vulnerable appear resources stocks. Prices for base metals and crude oil have now fallen below what most securities analysts have pencilled in for the year. This, logically, opens the door to further cuts in earnings forecasts. Luckily, most share prices are well below price targets, so there is a lot of room to wiggle for loyal shareholders.

– From a technical perspective many commodities and share markets simply look ugly, ugly, ugly. It's all fine for fundamental analysts to point at intrinsic valuations and the latest economic data, but both factors are in essence backward looking and subject to changes in the months ahead. Sometimes the market as a whole is smarter than each of us individually. I believe this is why, at critical junctures, technical indicators can sometimes point towards a change in trend that is not yet visible to most observers.

– Global equity markets are now trading below 200 day moving averages. Hardly a sign that all is well on the global economic and financial front. This becomes even more the case with commodities also having sunk below 200 day moving averages. In Australia, and despite two positive sessions in a row, the 50 day moving average is at the point of crossing below the 200 day moving average. This is, from both a trend and a momentum point of view, a negative development. There is simply no other way of putting this.

– On the matter of 50 and 200 day moving averages crossing over (the so-called Cross of Death): late last year, CSL ((CSL)) shares experienced the negative cross-over and this has kept the shares from rallying higher for a while, but ultimately CSL shares managed to recover and surge above both trend-lines, thus reversing the technical outlook. Taking a leaf from the CSL book, the least we should assume is that Australian shares are looking towards some tough times in the months ahead.

– What strategists at Deutsche Bank cannot predict (nobody can) is whether investors will still be prepared to value the Australian share market on average at 14 times earnings estimates for FY11 when earnings estimates are in decline (even by only 5%) and economic data remain shaky. My best guess is that, unless the overall landscape brightens up considerably, this will prove not to be the case. So even if today's optimists prove to be correct and present earnings estimates remain largely intact, lower than usual PE multiples will likely keep a lid on upside potential.

– There can be little doubt that certain stocks look like great value at current share prices. BHP Billiton ((BHP)), for example, is currently trading at some 8 times FY11 consensus EPS (USD estimates translated into today's AUD value). Even if we were to take a very bearish stance on global growth, this would still leave plenty of room for future earnings downgrades. However, value in itself is seldom enough to inspire share prices into closing the valuation gap. We need momentum too, and confidence, as well as a more positive technical picture.

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

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