REPEAT Rudi’s View: Return To The Mean

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(This story was originally published on Wednesday, 2nd February, 2011. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

It's one of the world's oldest cliches, but true nevertheless: nothing lasts forever. In share market terms this means: be careful when you continue jumping on yesterday's trend. History shows trends do reverse and gaps do narrow, even as the exact timing remains uncertain. As a matter of fact, a few trends from 2010 may have already come to an end in January. Time to reconsider a few truths from last year?

Let's start with the Australian share market in general.

In what has been a perfect example of "be careful what you wish for", the Australian share market partially decoupled from US equities in 2010. This has translated into a significant outperformance for US equities over the Australian market. Alas, the first month of 2011 has simply brought more of the same. So what's bugging investors and keeping them away from Australian shares?

Firstly, from an international perspective, a currency at parity with the USD represents elevated risk. If a correction follows, and most experts seem to think it will at some point, the weaker AUD can instantly sweep away all profits made in the share market. Not something many international fund managers are happy to take on board. Secondly, house prices in Australia are amongst the highest in the world, and looking wobbly. Even if local experts don't see any catalyst for a sharp retreat in Australian property prices, international investors prefer to play it safe, having experienced collapses in Spain, the UK and the US, to name but a few.

In addition, the US economy seems to offer much better upside potential, given the depth it has fallen since late 2007. Australia weathered the storms of the international credit crunch well, because of peak immigration not because of commodities, but two years down the track this has merely become a case of "less pain, less gain". There's not as much upside for the Australian economy as there is elsewhere and this should, all things being equal, limit profit growth potential for Australian companies. Add the fact the RBA has an ongoing tightening bias, plus some weather disasters and it should be clear Australia is no longer top of priority lists internationally.

But no other factor makes it as clear as to why Australia's underperformance has been justified as do analysts' earnings expectations. Earnings forecasts for Australian companies have been in decline since May last year. They have been on the rise internationally since August. It can thus hardly be a coincidence that the gap between Australia and the rest of the world really started opening up from September. This downward trend has ceased in late 2010, but only because analysts have been upgrading their commodity prices forecasts for the new calendar year. Excluding commodities, earnings forecasts in Australia are still in decline.

This easily explains Australia's underperformance. Resources and energy stocks, plus their pick and shovel providers, represent an estimated 33% of the ASX200. This means 67% is still suffering from downward adjustments in growth forecasts. Plus BHP Billiton ((BHP)), today's largest stock in Australia, hasn't exactly performed splendidly over the past twelve months (more on BHP further down).

The gap between resources and the rest has consistently widened throughout 2010. Market strategists at UBS predict resources companies will report some 40% in earnings growth this year, while "industrials" will only report growth to the tune of 4.5%. This is, give or take, a factor of 10 to 1. ANZ Bank economists recently calculated resources account for 6% of Australia's GDP, but also for 40% of all corporate profits in the country. These are truly amazing numbers, but could it be that they also signal we are currently at or near the peak for the gap between resources companies and the rest?

If so, than we will, at some stage, witness a reversal in the relative de-valuation of 67% of Australian companies vis-a-vis the resources industry.

Similarly, while it appears the same factors that were dogging corporate profits in 2010 will largely remain in place this year (even though the RBA might allow for more breathing space at first post the natural disasters in Queensland), history shows the Australian share market has been the best performer overall since 1900. Every period of relative underperformance (1970s, 1990s) has ultimately been followed by relative outperformance. Within this framework, I note AMP's Head of Investment Strategy and Chief Economist Shane Oliver, suggested in January:

"On a five-year basis, the combination of higher dividends, better growth prospects, fewer structural constraints and franking credits for Australian-based investors suggest investors should maintain a bias towards Australian shares."

Rule number one from investment legend Bob Farrell: "Markets tend to return to the mean over time".

Here are a few more trends that come to mind:

– Banks outperformed in the initial phase of the post March 2009-rally, but they turned into significant underperformers towards the end of 2009, and have been since. Price-Earnings ratios for banks are now historically low, and prospective dividend yields historically high, while EPS growth projections are as low as I have seen them over the past decade. Commonwealth Bank ((CBA)) has held a stiff premium versus the rest of the sector over the past two years.

– Small and medium sized companies have significantly outperformed their larger peers since March 2009 and within that group smaller mining stocks have significantly outperformed their peers in industrial sectors. Smaller companies are now trading on equal valuations with large caps, which doesn't make sense from a longer term risk perspective.

– BHP Billiton shares may have performed slightly better than the market overall in the year past, the shares underperformed many other stocks, including Rio Tinto ((RIO)). BHP is cash rich but the market doesn't want Marius Kloppers to chase the next big company-changing, milestone acquisition. Analysts are convinced that if BHP decides to stick with what works best and returns its surplus cash to shareholders, the shares would enjoy a premium compared to the present discount. Are Marius and others on the board listening?

– Retailers have been de-rated on the back of an increasingly toughening environment. If it isn't the currency, it's higher interest rates, or the weather, or a newfound frugality among Australian consumers, or online competition. There's always something so it seems and retailers have become the standout sector for issuing profit warnings over the past three months. However, immigration is about to pick up, the overall savings rate is back at 10% and a tight labour market should feed into upward pressures on wages. Is it safe to assume the sector is experiencing the pinnacle in its discomfort zone? If we forget about the fact that many retailers are lagging in terms of online operations, then the answer is probably yes.

– Inside the retail sector, Wesfarmers ((WES)) has now consistently outperformed Woolworths ((WOW)) over the past two years. Woolworths shares are currently trading near their lowest PE ratio over the past decade. Already a few retail analysts have started mumbling "relative value".

– Probably comparable to the de-rating for retailers in Australia is the preceding de-rating for bricks and mortar media companies in Australia. As has been well-established now, a few years ago when private equity jumped through all sorts of hoops to get its share of local media companies, and James Packer successfully offloaded his father's legacy, that marked the ultimate peak for the local media sector. Valuations have fallen dramatically since and a virtual non-existence of online strategies among Australia's media companies is still hurting prospects and valuations today.

– Companies in the building materials space continue to do it tough, and their share prices have been significantly de-rated. No growth in Australia and negative growth in the US does not exactly make for a prosperous combination. It would appear the immediate outlook remains sombre and things in the US might well turn worse, before they can get better. At some point, however, investors will start looking at cheap valuations and at market conditions that will, inevitably, start improving. Most experts believe a recovery in US construction won't come before 2012. That may well mean investors will start casting an eye over the sector at some point before the end of the year.

– Equity markets in developed countries, including Australia's, have continuously suffered from net funds outflows since sell-offs started in 2008. Stockbrokers have been predicting (hoping?) this would change at some point, but despite international equities booking solid gains in 2009 and 2010, retail investors chose not to return to equities. This might be about to change with retail stockbrokers in the US signaling January might have seen a potential reversal in trend. This could be very important for US equities in the year ahead. In Australia, retail investors still love high yielding instruments, such as cash in the bank.

– Businesses worldwide have deleveraged since the proverbial hit the fan in 2007. Corporate cash levels are at much healthier levels and 2010 might have shown the first signs that company boards are increasingly leaning towards spending instead of hoarding. In Australia, one prediction is that dividend payouts will further increase this year.

– Also, history shows commodities seldom outperform each other year-in, year-out. More often than not, last year's number one will revert back to the centre of the field, if not straight to the bottom of relative performances in the following year. In 2009 copper, lead and zinc clearly outperformed all others, but last year lead and zinc ended near the bottom of the performance list (zinc even put in a negative return). In 2010 palladium was the best performer, with silver second and corn third. Relative laggards were (from the bottom up) natural gas, zinc, lead, aluminium and crude oil. Something to keep in mind for this year?

– To complete the above picture: in 2008 only gold put in a positive performance while lead proved the worst of the pack. As stated above, the next year lead returned the second best performance and gold fell back near the bottom of the pack. Last year gold ended in the middle.

While putting an exact timing on any or all of the above remains anyone's guess, I add the following observations:

– Large caps outperformed small caps in January
– Australian Real Estate Investment Trusts (A-REITs) outperformed the broader market
– Equities in emerging markets underperformed those in developed countries
– Precious metals underperformed the broader commodity complex
– The Australian dollar is no longer on top of FX performance tables
– History suggests larger resources companies outperform their smaller peers in year three of the commodities boom

No doubt, I am forgetting a few. Ideal opportunity to quote one of Wall Street's legendary traders, Jesse Livermore: "The big money is made by the sittin' and the waitin', not the thinking".

Below a chart (thanks to Shane Oliver at AMP) to illustrate what I have been talking about since April last year: earnings forecasts in Australia have been in decline, while the rest of the world fared much better. One does not have to seek any further about why the Australian share market has been de-rated over the past year. Remember: nothing lasts forever, even if tomorrow might still look the same as it was yesterday. And oh yes, everything has a price.

(Special note: FNArena subscribers can read all ten investent rules by Bob Farrell, along others, in the Take Notes section on the website).

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

 

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