Rudi's View | Nov 14 2006
By Rudi Filapek-Vandyck
Time for a correction?
Global equity markets have resumed their upward path with many of them, including the Australian stock market, now at or close to levels experts had penciled in for the end of December. No wonder thus that several market commentators have recently issued calls for what should be regarded “an overdue pullback in an ongoing positive uptrend”.
At a first glance, these views do not seem to be supported by FN Arena’s proprietary Bull/Bear Indicator which only recently has started to recover from the May month’s slaughter fest. It hasn’t been an easy year for the indicator which is based upon the relative amount of Neutral recommendations on individual ASX-listed stocks out of the total amount of recommendations issued by ten leading stockbrokers and equity researchers in Australia.
The experience from the past few years had taught us the index (and thus the amount of Hold/Neutral recommendations) usually moves between 51-55% with breaks outside this range usually followed by either a surge in share prices, or a correction to pull the index back into the range.
But 2006 has been nothing like the previous years. Ever since the May correction the index has languished below 50% and it took an unusually bullish October month, and eight weeks of recommendation downgrades outnumbering upgrades, to finally push the Bear/Bull Index back to 50.50% again. This remains below the 51-55% range, suggesting there’s still sufficient value in today’s share market to sustain further price rises.
Even if we forget all about the indicator, any share market wherein more than 36% out of all stocks covered by the leading experts carries a Buy recommendation can only be considered good value. (Sell recommendations currently account for 13% of the total).
However, when we add the implied upside from today’s share prices compared with average twelve month price targets to our analysis, a different picture emerges.
FN Arena’s stocks universe comprises of nearly 500 ASX-listed companies. In essence, these are all the stocks that are at least covered by one out of ten leading experts we monitor. In practice this means our universe consists of most constituents of the ASX300 index and circa 200 smaller caps, and News Corp (NWS) of course. As at Monday November 13, 2006 only 32% of all these stocks were estimated to have at least 5% in potential share price appreciation left. Most of these 32% are not a member of the ASX200 or ASX300 indices.
If current average price targets prove to be correct over the coming year, 31% of all stocks in our universe should be trading at a lower price level in twelve months from now. This leaves 37% of stocks with a projected low single digit share price potential. All of a sudden, the Australian share market doesn’t look that enticing anymore, does it?
How to explain the dichotomy between the current still large amounts of Buy recommendations and the rather pricey looking share price valuations?
Let’s take one example from this week’s securities analysts research reports.
Shares of gaming company Aristocrat Leisure (ALL) have swiftly recouped previous losses following product delays in the Japanese market. Investors seem to have bought the idea that any weakness in Japan will be more than compensated through ongoing strength in the US markets.
The surge in share price hasn’t escaped analysts at Deutsche Bank, but while on tour visiting Aristocrat’s operations in North America the analysts report they’d rather not make any changes before returning to Australia. Expect a recommendation downgrade soon after they’ve set foot on Australian soil as Aristocrat’s share price has now exceeded the broker’s price target, and is still rising. (ABN Amro analysts who are on the same tour showed no such reticence and simply downgraded the stock to a Hold on Tuesday.)
Aristocrat is currently rated Buy at three other brokerages, but only JP Morgan’s price target at $15.60 is still above the share price ($14.95 at Tuesday’s close). With a projected share price potential of 4% and an estimated dividend return of a little above 2% left Aristocrat shares seem hardly the kind of stock any investor would want to chase aggressively considering Australia’s leading share market indices are close to all time high levels again.
Yet, four out of ten experts monitored by FN Arena rate the shares a Buy.
Two of these experts, JP Morgan and Macquarie, hold a subdued view on the prospects of the Australian share market in the year ahead. In other words: Aristocrat’s outlook may not look flash in total return numbers, but most of other stocks should do worse in both brokers’ view.
The positive input from the US tour would need to cause Merrill Lynch and Deutsche Bank analysts to significantly increase their current price targets in order to justify continuing to rate Aristocrat shares as Buy.
Aristocrat is only one example. Stocks such as AMP (AMP), Cabcharge (CAB), Energy Resources of Australia (ERA), JB Hi-Fi (JBH), Metcash (MTS), QBE Insurance (QBE), Tattersall’s (TTS) and Zinifex (ZFX) -to name just a few- are all in a similar position.
The reason why some experts continue to rate these stocks positively is because they suspect more positive surprises lay ahead. In ERA’s case for instance it is anticipated the price for uranium will surge further in the near term. In the case of QBE it is the absence of a major natural disaster (so far this year) which may open the door to unexpected capital management.
There’s also the omni-present chance of corporate activity. Since the arrival earlier this year of large offshore private equity providers in Australia, the amount of Merger and Acquisition (M&A) proposals has picked up sharply. The amount of rumours has gone through the roof.
Of course, not all corporate approaches will lead to a successful transaction and neither will each rumour prove to be more than hot air, but with the Federal Government about to change the media ownership rules, who’d be willing to put a Sell recommendation on, let’s say, Fairfax (JFX)?
(Actually Credit Suisse did so last week but the broker’s negative stance is more than compensated by Buy recommendations from three other brokers).
It’s probably a correct assumption to make that were it not for a sharp pick up in M&A activity the Australian share market would not be where it is today, but at lower levels instead. At the same time it’s a pretty useless assumption too since the M&A theme is amongst us and unlikely to go away anytime soon.
The assumption is in essence incorrect too: it’s global liquidity and not private equity that is currently driving (part of) the Australian share market. In a nutshell: companies worldwide are flush with cash, banks are willing lenders, interest rates in major economies are still accommodative (the yen carry trade is still alive) and many economic markets are at or near an inflection point. The latter means many companies will have to seek growth through acquisitions.
Probably equally important is that global risk appetite remains at historically elevated levels. That’s why hedge funds are now considering listing at stock markets. And that’s why private equity companies have no problem in raising sufficient funds to pay significant premiums above what share market investors are willing to put on the table.
On Morgan Stanley calculations, and depending on which deals will materialise and when, about $10bn in excess funds will be seeking re-allocation into the Australian share market between now and mid-2007. This is after index reshufflings, new inclusions, and funds reallocations to new index inclusions. The second installment of T3 will “only” be able to absorb circa $4.5bn and most likely come too late into next year anyway (scheduled for late 2007).
In early May, just before the major share market correction, more than 36% of stocks in the FN Arena universe were projected to appreciate by at least 5% in the year ahead. 37% of stocks had a negative outlook. Share indices had just entered unchartered territory at the time.
Assuming the bottom group is the better indicator of the share market’s valuation, we probably still have several percentages to go before we reach the same 37% level again (we’re at 31% now). Considering the time of the year, this may well indicate we can still have our traditional end of year rally before it’ll be time to let off some steam again in early 2007. As it happens this is likely to coincide with some weak US economic data.
After that, $10bn will be looking for a destination. At least.