Rudi On Thursday

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

(This weekly editorial was first published on Wednesday, January 14, 2009. It has now been re-published to make it available to non-paying members at FNArena, and other readers elsewhere.)

The two key words for today’s investor in the share market are, in my view, “timing” and “risk”.

Because the timing of a lot of things remains uncertain, investing in shares today still comes with above normal levels of risks. Judging by how fragile share markets have performed during the first two weeks of the new year, I think it is only fair to say that, as a collective, investors are all too aware of this.

Let’s start off with some good news though: journalists at Bloomberg television pointed out this morning the first two weeks of the new calendar year have thus far generated the fifth worst start for US equities since 1927.

But…

Last week already, strategists at Citi pointed out that what is often referred to as “so goes January, so goes the rest of the year” in essence applies to the first five trading days of the year. In other words, history shows that if the first five trading days of January are upbeat, the remainder of the year should ultimately be positive as well.

This just shows in how many different ways one can juggle historical data and analysis.

But…

If Citi’s analysis proves correct, the current year should on balance generate a positive return for investors. Now all we need to complete this picture is the “timing”; when-oh-when?

Global strategists at UBS asked themselves four questions considered key for the outlook of financial markets:

1. Will value be the key driver of returns in 2009?
2. Are global equities really that cheap?
3. Given massive fiscal issuance, are investors crazy to hold Treasuries and other government bonds, particularly with yields near record lows?
4. Every strategist loves credit: Should you?

None of the answers they provided will surprise you.

Investor sentiment, more than calculated asset valuations, will remain the driver behind financial markets for a while yet. After all, expectations by economists across the globe are still falling, forecasts by securities analysts are adjusting and will soon reflect more realistic scenarios, and governments and central banks are doing their best to prop up businesses and consumers, but at the end of the day nobody knows what will ultimately work, and how, and when – and thus there is little value in value itself.

The above paragraph does not come from UBS, but from me, but believe me it is perfectly in line with what the strategists want to get across: investors need to be convinced that all these massive stimulus packages put in place around the world will actually work, and that credit conditions can improve sustainably.

So far, any proof of either the first or the latter has been tentative and ambiguous at best.

UBS strategists don’t believe shares are particularly cheap either, despite many other experts arguing to the contrary. In the end, it all boils down to what lies ahead. If 2009 will bring us a slow economic recovery, in combination with sharply lower corporate earnings, argues UBS, current price-earnings ratios (PERs) are closer to “fair value” than to “cheap”.

Of course, we are about to find out what the exact meaning is of sharply lower earnings with the Q4 reporting season in the US having started this week, but with the bulk of reports coming out over the next two weeks, and with the bulk of the half-yearly reporting season in Australia following in February.

However, and in all likelihood, we will probably have to wait until August-September to find out exactly, and whether current investor optimism can be justified.

Strategists at BCA Research believe it would be a good idea if investors don’t allocate their funds for the full 100% just yet. Opportunities will come along and open up in the months ahead, argues BCA, better to have some ammunition ready to take advantage of them.

Similarly, say UBS strategists, the answer to question number three is all about “timing”. Bond yields can remain low in the face of big government budget deficits so long as monetary policy remains very easy and nominal GDP growth is weak, say the strategists. What this means is that at some point “the day of reckoning” will arrive for US Treasuries, but that moment is not now.

But investors should love credit too, UBS believes, because current high yields on corporate bonds are largely a reflection of illiquidity premiums. As such, current spreads adequately compensate investors for rising default risk. (The strategists believe investors should be overweight corporate bonds with focus on investment grade credit).

The latter view is in line with the opinion of many an expert elsewhere.

In general, the position of UBS strategists towards asset allocation/portfolio building continues to have a cautious and conservative bias. Strategist at Deutsche Bank last week displayed a similar level of caution, and so did a report published by Bank of America-Merrill Lynch this morning.

What I picked up from Quantitative Strategist Nigel Tupper’s analysis, however, was that the Australian share market has behaved differently than most other share markets throughout this bear market so far. Dividing the share market into “Bunkers” (defensives) and “Boosters” (stocks with high alpha), Tupper’s analysis seems to suggest that the differences in monthly performances between these two groups are much more pronounced in Australia, with much larger outperformance figures recorded in about half of the months for “Boosters” (compared with share markets elsewhere) but also relatively benign outperformances in other months by the more defensive stocks since January 2008.

I am not quite sure what to make of this, other than that investors in Australia seem to think that owning stocks such as Woolworths ((WOW)), Foster’s ((FGL)) and Australian banks is simply boring, and they are thus more than their peers elsewhere willing to jump on the bandwagon once the market pendulum swings into favour of energy and resource stocks again?

Market strategists at Macquarie updated their market return projections on Monday. As at 6 January 2009, Macquarie’s modeling suggests the Australian market (S&P/ASX 200) should generate a total shareholder return of 25.5% this year, comprised of a capital return of 21.7% plus a dividend yield of 3.9%.

Macquarie has a target level for of the S&P/ASX 200 index of 4553.

Delving into these calculations with more detail, Resources are forecast to generate a total return of 12.5% this year compared with 30.7% for Industrials. For the Small Ordinaries, Macquarie’s total projected return is 25.9%, comprising a capital return of 22.4% plus a dividend yield of 3.5%. Small Resource stocks are expected to generate a negative return of -32.5%, while the Small Industrials is currently forecast to return a whopping 49.1% for the year.

However, say the strategists, it is unlikely that any share market rally will prove to be sustainable until the true “health” of corporate earnings and demand has been revealed through the February reporting season.

In a separate report this morning, Macquarie strategists reiterate that previous historical analysis has already shown that until market expectations for corporate earnings stop falling, the share market cannot find enough confidence for a sustainable rally. In other words, it’s not the turn in corporate earnings, but the turn in earnings expectations that will prove key for the share market this year.

It is this reversal in earnings per share growth forecasts, rather than PER expansion, that will drive the share market out of the downturn, says Macquarie.

Believe it or not, but these were almost exactly my words during the presentation I gave about the Bear Market in September last year (and which has provided the content for our DVD “Dealing with the Bear”).

Special memo to all analysts out there; what are you waiting for?

Because of all of the above I remain of the view that long term investors should focus on sustainable dividends.

With these thoughts I leave you all this week,

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab team of Andrew, Chris, Grahame, George, Pat, Joyce and Greg)

Click to view our Glossary of Financial Terms