REPEAT Rudi’s View: More Upside For Equities In 2011

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(This story was originally published on Wednesday, 2 December, 2010. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere.)

By Rudi Filapek-Vandyck, Editor FNArena

It still is one of those Big Mysteries for investors the world around; why is the Australian share market so lacklustre when its economy is Best of the League, offering direct exposure to rampant Asian growth and demand via diversified giants such as BHP Billiton ((BHP)) and Rio Tinto ((RIO))?

The answer has come through some very subdued economic data this November and today's first estimate of GDP growth for the September quarter was no exception, revealing that if not for a strong contribution from agri-exporters, the Australian economy would have printed a negative growth figure for the third quarter. Add some downward revisions to previously released estimates for Q2 and Q1 and the Australian economy at this point is actually growing below trend (2.7% vs 3.25%).

Today's GDP release by the Australian Bureau of Statistics also instantly answers the question as to why financial markets always respond negatively whenever there is even the slightest hint of further tightening measures in China. It's because when central bankers embark on a tightening mission, they tend to ultimately achieve what they are aiming at, and that is an economy progressing at a slower pace. See: Australia – RBA – Q3 GDP.

Neither the People's Bank of China, nor the Reserve Bank of Australia are believed to be at or near the end of their tightening cycle. So this parallel will continue into 2011.

I know what some of you are now thinking. Next thing he tells us the sovereign debt problems in Europe won't be solved this side of Christmas either. Whatever happened to "A Better Year Ahead Next Year"?

This might come as a surprise, but that might still be the case. While scenarios for Asia (including China and Japan), for Europe and for Australia seem pretty much pre-determined at this stage, the unknown factor remains the world's largest economy. And while most investors (and media) have been pre-occupied with Irish banks and angry demonstrators, with more policy actions in China and with relentless bank-bashing in Australia, economic data in the US have continued to surprise to the upside, with many equity strategist around the globe now believing the US economy might well become THE surprise factor next year.

The reasoning goes somehow as follows: thus far the US economy has remained in a deep slump and global expectations are low. The lack of sales growth has forced US companies into a lean-and-mean operational mode which has allowed companies to continuously beat Wall Street expectations throughout the second half of 2009 and 2010. While the world remains highly skeptical as to the sustainability of US corporate profit margins (low expectations) investors are probably underestimating what effect a little bit of top line growth can have for next year's profits. So assuming the current trend of better than expected economic data can last into next year, the US stock market should remain poised to surprise to the upside.

This, of course, would be good news for risk assets across the globe, including commodities and equities in Australia. It would likely add more than just a smidgen to next year's overall demand (the US remains the largest economy), but it would also disconnect the inverse relationship between the USD and risk assets that the world has become addicted to over the past three years. Consider also that almost no-one believes that Bernanke and Co at the Federal Reserve will cease their programme of Quantitative Easing Part Deux and what we could see is a rather powerful combination of supportive factors for the US share market in 2011.

Institutional trader and stockbrokerage BTIG rolled out its US based market strategist Mike O'Rourke this week for a conference call to convey a similar message to journalists in Australia and in Asia. O'Rourke's reasoning was along the lines I descibed above, but with the added observation that US stockmarkets have now suffered from net funds outflows for 3.5 years. To reverse this trend investors need increased confidence, says O'Rourke. He predicts two main factors will lead to such increased confidence: better economic data and record high corporate profits.

It only takes about 5% growth from this year's reported earnings per share to put next year's EPS for US companies at a new record high, points out O'Rourke. He thinks growth will be better than that, something along the lines of 10-12% or so. This means US corporate profits are about to hit a new all-time high, bettering the levels witnessed in 2007. It is the realisation of this achievement that will pull investors back into the US share market, he says. Another stand-out observation is that the second half of 2010 will end up with a noticeable disconnection between US corporate profits and the share market. In other words: watch out when the current lid on risk appetite disappears, because share prices in the US have some catching up to do.

O'Rourke predicts a period of USD stabilisation, which will assist financial markets in their focus on growth, on improving global fundamentals and, of course, on growing profits for US companies. This could prove quite a powerful combination as the world, in O'Rourke's observation, is still very much defensively positioned. As a matter of fact, during the conference call O'Rourke stated he doubted whether investors worldwide had ever been invested as defensively as at this point in time. Imagine if only part of those funds would start seeking a higher return in the US share market…

It's a daunting scenario, and certainly many strategists and investors would be hoping these will be the main ingredients for 2011.

However, at PIMCO market strategists are not so sure about this equity-centric outlook for next year. What implicitly lies embedded in forecasts such as O'Rourke's is that funds will flow out of bonds and into equities and commodities. PIMCO on the other hand believes such scenarios are too much based upon a return-to-the-mean in the correlations and relationships between financial assets, one that would see global bond yields "normalise" back to higher yields. PIMCO believes investors banking on this happening next year are dreaming, because the outlook remains for many years of sub-par growth in developed economies, and thus bond yields will remain low for a long time.

Earlier today, PIMCO mailed out a press release and the following three statements, all ascribed to Senior Vice President, Tony Hildyard, say it all:

"We believe these mean reversion-based recommendations are out of date as they ignore current economic realities in a world struggling to recover from the liquidity and leverage driven excesses that ended with the global financial crisis."

"A significant proportion of historical economic growth can be traced back to excess liquidity and leverage (borrowing) and we believe this is unlikely to be repeated in the near-term."

"In fact, for the first few years of the corrective phase, global growth has the potential to trend even lower as deleveraging and high unemployment constrain consumers."

Others, such as Bell Potter Director Of Research Peter Quinton, argue that references to past PE valuations for equity markets are likely misleading as investors are more likely to put lower multiples on such a lower growth environment. Quinton also argues, rightfully, this shouldn't mean there's no upside left for equities.

But what investors will have to get used to are lower returns from equities, argues Quinton, which is why he believes investors' focus will increasingly shift towards high dividend paying stocks, which brings us back to one of the key themes in the investor presentations I gave in October and November: quality dividend paying stocks have generated more than half of total investment returns in the Australian share market over the past hundred years or so. In fact, I recently attended a presentation on high dividend yielding stocks, organised by Russell Investments, and was told that over the past decade dividends (including franking) made up more than three-quarters of total investment returns from the Australian share market.

I intend to follow up on this theme shortly. For now, I have included the chart that backs up the claim:

P.S. – I strongly suggest subscribers also read this week's Weekly Insights "The Widening Gap Between The Haves And The Have-Nots"

P.S. II – 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.

P.S. III – If you are reading this story through a third party channel and you cannot see the charts included, I apologise, but technical limitations are to blame.

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