FYI | Apr 29 2009
By Chris Shaw
The near 25% rally in global equity prices since the beginning of March is something of a good news/bad news story.Russell Investments in its latest monthly review suggests most market analysts view the move as little more than a bear market rally, but even after factoring in the rally since March, Russell still believes equities remain attractive on long-term valuation metrics.
The rally has been driven by three main factors, these being the recent surprisingly good profit guidance from Citigroup, support for the bank toxic asset plan in the US and so called “green shoots” in some US economic data, these including gains in consumer spending and signs of some stability in the US housing market. Also supportive is while the ISM Manufacturing index remains below a reading of 50, indicating contraction, it has risen for the past three months and this is a more positive trend.
The issue according to Andrew Pease, the group’s investment strategist for Australasia, is while there is long-term value it will be a tough road for this value to be recognised as volatility remains high and the likely low global economic growth in coming months. Also, the unwillingness of banks to lend money will limit any possible outperformance.
This volatility, with the VIX (Chicago Board Options Exchange Volatility Index) currently at around twice its long-term average, and the potential for more bad news is why the balance of expert opinion is the current rally is a run in a bear market. This is especially the case as Pease notes there remain concerns losses yet to be revealed on US balance sheets will wipe out much of the equity capital of the banks, which would result in a substantial portion of the sector having to be nationalised.
The opposite view is the amount of fiscal and monetary stimulus being provided, and as an example Pease notes the balance sheet of the US Federal Reserve is expected to grow from less than US$1 trillion a year ago to around US$4 trillion by the end of this year. This will prevent the recession sliding into depression he adds. Such an outcome would mean the worst is likely over, assuming the US banking sector passes its stress test as such an outcome will add validity to the current equity market rally.
In terms of value being evident in equities, Pease notes Russell’s model suggests at current levels Australian equities are undervalued by as much as 40%, compared to being overvalued by around 20% back in October of 2007. The group’s model incorporates 12-month forward earnings, 10-year government bond yields and a measure of the deviation of current earnings growth from long-term trends.
The rally has had an impact though, as Pease points out sector forward P/Es (price to earnings ratios) have drifted higher so far this year, as for example the P/E for the financial sector has risen from 8.7x late last year to more than 11x now, while diversified resources are currently on a forward P/E of around 16.6x.
At the same time earnings estimates have been revised down, as last September consensus forecasts called for 50% earnings growth over the next 12 months but now the market is factoring in a 17% decline in earnings in the next year. Given small caps are currently trading at a 21% P/E discount to large caps, Pease suggests the smaller cap stocks should outperform when equities rebound.
Real estate investment trusts in Australia also appear to offer some value. Pease notes REITS were at a 20% premium to the broader market early in 2007 and the sector is now at a discount of around 35%, while the distribution yield is 650 basis points above the 10-year bond yield. This, he points out, is a good indicator of value. Given the sector typically outperforms equities in the year after the sector P/E ratio declines relative to the broader market, Pease sees some scope for the sector to outperform over the next 12 months.
One issue Pease notes is while equities have rallied over the past several weeks the optimism has not spread to credit markets as the spread between US high yield securities and government bonds remains quite wide, which is also a by-product of the recent volatility in markets and a lack of liquidity, as well as a fear what liquidity there is could quickly evaporate if conditions again worsen. The result is on the group’s model global credit looks cheap but government bonds appear expensive, with investment grade credit appearing far more attractive at current levels.
In foreign exchanges, the group sees the Austalian dollar as around fair value at current levels relative to the US dollar, so while no clear direction is indicated the balane of risk suggests some appreciation in the Aussie currency in coming months given it is a good reflection of investor risk appetite.
Offsetting factors are the fact interest rate differentials continue to move against the Aussie dollar, while commodity prices are also doing the currency no favours and further pressure may come from lower contract prices for iron ore and coal in coming months.
