Treasure Chest: Trading Strategies Into 2014

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By Greg Peel

The Australian broad market has been soggy this past couple of weeks, failing to find fresh reason to rally. Yet nor does any major pullback look imminent, given yield support tends to kick in fairly quickly at any sign of weakness.

JP Morgan sees Australia in the “sweet spot” of a global liquidity-driven rally, given its high yield status. Yet having suffered quite a sharp correction when it was feared such liquidity was nearing an end – when Fed tapering talk first emerged in May – not a lot of this underperformance has been recovered. JP Morgan believes a lack of credible earnings growth stories among the large caps, meeting strong prices on liquidity support, is pushing price/earnings multiples into “uncomfortable” territory.

Those with a bullish bent are assuming current PE levels are actually lower than they appear based on an anticipated earnings upgrade cycle from here (hold P fixed, increase E, and PE falls). But where is the macro or micro support for earnings upgrades? JPM asks. Most sectors are already posting earnings above cyclical lows and industry margins cannot become much more supportive. Consensus forecasts are currently suggesting average 12% earnings growth (cap-weighted) in FY14. While earnings forecasts are typically always ambitious, the analysts fear any further positive “green shoot” news might push forecasts higher into more than just ambitious territory.

JP Morgan expects a weak Australian jobs market may prove the decider, and the Australian economy is looking not much better than sluggish at present.

On an Australian macroeconomic level, a stronger housing market is balancing against ongoing reluctance to hire and weak credit growth. The analysts are prepared to rethink if jobs and lending figures improve but at the micro level, many companies have admitted recently, during the AGM season, there is little sign of immediate improvement ahead.

Which brings us to stock picks.

JP Morgan believes the Aussie will finally begin to weaken in 2014 as it becomes apparent local growth is really just not happening. This call suggests investing in stocks benefiting from such a currency move, and the broker likes ResMed ((RMD)), Brambles ((BXB)) and Sims Metal Management ((SGM)).

The broker believes the Coca-Cola Amatil ((CCL)) structural decline story is overdone, and likes Crown ((CWN)) for its exposure to rising Asian consumer spending and emerging market growth, via Macau.

On the “avoid” side of the equation, JPM is not keen on Fletcher Building ((FBU)), which is overpriced, ALS ((ALQ)), which cannot avoid a still weakening commodity capex cycle, and Cochlear ((COH)), which is too highly rated given pressure on growth expectations.

When it comes to equity investment strategy in 2014, Credit Suisse’s strategists have declared that “bottom-up” is back.

Since the GFC, investment has been all about a “top-down” approach, implying one starts with the macro picture (very volatile globally in 2008-12) and base one’s portfolio allocation thusly. But 2013 has proven a year in which a lot of macro fear has waned, and hence fear of another big sell-off has dissipated (with global monetary policy obviously playing safety net). Top-down is thus no longer as applicable. Hence rather than trading the stock market as a whole, it’s now time to trade individual stocks based on individual stories. This is the “bottom-up” approach.

Specifically, investors should focus on valuation from both a PE basis and a free cash flow yield basis, suggests Credit Suisse. (Free cash flow yield implies dividends paid from legitimate operating profits and not from debt or any balance sheet manoeuvring.)

Underlying this micro strategy suggestion is nevertheless an ongoing macro picture of global monetary policy support – the safety net, or “free put option” in market parlance. BA-Merrill Lynch believes the global economic cycle is improving but not yet by enough to suggest policy tightening (eg Fed tapering). Merrills thus remains bullish on global equities as a whole, and recommends using any pullbacks as buying opportunities.

Merrills’ global quant analysts point out that when the “global wave” is rising, investors should nevertheless turn their attention to those “styles” of trade (rather than specific stock/sector differentiation) that tend to outperform. Those styles, the boffins declare, are Value (oversold), Growth (earnings upside), Momentum (the trend is your friend), Risk (cyclicals) and Small Caps. Which, it has to be said, is just about everything, other than Quality (safe plodders). Merrills notes such a strategy, including avoiding Quality for quality’s sake, has worked all through 2013.

Based on such a strategy, the quants have come up with a “Global 50” portfolio they believe fits the bill. Of the fifty, four stock recommendations hail from the Asia Pacific region, twelve are in Europe, six in Japan, two in Brazil and the balance is North American. Of the Asia-Pac four, only Fortescue Metals ((FMG)) is Australian.

Maintaining focus on Asia-Pac, Merrills Asia-Pac quant team has also chimed in. Taking the global “style” theme as a backdrop, the locals further note large global investors are currently Underweight Asia, and may be tempted to turn if relative liquidity troughs, stagflation looks like dissipating or earnings expectations improve.

When looking at Value, Growth, Momentum and Small versus Quality, the Asia-Pac quants note Value has actually underperformed in recent years but could reverse on signs of an upturn. Such an upturn would also render overpriced Quality out of favour against inexpensive Risk. Maintaining exposure to yield stocks is fine but “cyclical yield” should now be sought, where both yield and capital gain are on offer. The biggest risk is to hang on too long to defensives as the economy gathers speed, the quants warn. Don’t be caught short in Materials and Energy when the economic recovery gains momentum.
 

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