Four Phases Of Asian Equity Markets

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By Greg Peel

Asian markets, say Citi's Asia Pacific equity strategists, tend to move in four phases over time. (“Asia” here means ex Japan as Japan is considered a mature and thus “Western” market for comparison purposes).

The fourth of these phases is that of collapse, which is where we have been because of the GFC this time, but we will return to Phase Four in a moment. Assuming a collapse has occurred, Phase One represents the recovery from the lows. This phase tends to last 12 months and features high price/earnings (PE) multiples because the market is applying a price to earnings that will come eventually but not right now. Investors are getting in early to effectively buy an “out-of-the-money call option” on earnings recovery.

Once prices have pushed up to a point where the market is satisfied with its pricing for future earnings (average return 59% in this phase), Phase Two begins. Phase Two might be called the “show me the money” phase in which investors look for confirmation of pre-pricing from actual earnings recovery. This phase tends to take 24 months and is much more of a slow grind than the rapid rally of Phase One. Companies do not suddenly wake up one day to find their earnings have returned to normal levels, rather earnings growth is a slow graft. In this phase investors need to be patient.

This phase will feature a drop in PE multiples because while prices won't move too dramatically, actual earnings will begin to catch up, that is the denominator will rise faster than the numerator. The average annual return over this two-year period is 20%.

Phase Three develops thereafter when the original downturn is now forgotten, earnings have normalised and investors go back to the momentum trade of believing stock markets just go up forever. PE multiples rise again more on sentiment than on earnings growth. Returns average 51% per annum and the phase lasts an average of 17 months.

Phase Four begins when the euphoria has pushed too far, when PE multiples have overrun realistic pricing and when, simply, the bubble bursts. The market collapses using the elevator and not the stairs. Citi offers no average return data on this phase nor average duration. Suffice to say that the average return on Asia (ex Japan) equities over 20 years is 5.3%, so if we have one year of 59%, two of 20% and another 17 months of 51%, you don't want to be in equities in Phase Four.

Currently, says Citi, we are in Phase Two. Now, Citi is providing numbers specifically for Asian markets but we can realistically assume that this four-phase pattern can be applied to mature markets as well. The difference is that immature markets tend to be more volatile, thus providing these big return numbers, but in the case of the GFC Western markets have swung through similar levels of volatility for the first time in a while.

The US and Australian markets have rebounded around 60% from the lows over a period of about a year and have now stalled. It looks like a grind upwards is the best we can hope for in the near term. In the case of Australia specifically we can contend that given the significant influence China's economy now has on Australia's economy, it is likely Australia will fall more into line with Chinese (and thus Asian) fluctuations.

Of course, if we're talking “grind”, we're referring to the index and not necessarily every single individual stock. There will always be stocks which outperform or underperform the index. One of the problems associated with a broker's “Buy” rating on a stock is that investors are unclear as to when to stop buying. To that end some brokers qualify their Buy ratings. GSJB Were, for example, has its “Conviction List”. For BA-Merrill Lynch it's an “Australia Focus One” portfolio.

Merrills qualifies its AF1 list as being “actionable buys” amongst its current universe of Buy-rated stocks, or “best ideas”. Given a broker rating typically is a six-to-twelve-month recommendation, some stocks are seen as a better trading opportunities than others.

Merrills today added transport logistics operator Asciano ((AIO)) to its AF1 list. The broker notes port volumes have been recovering strongly in 2010 to date and that coal haulage earnings in particular should jump significantly into FY11. Looking at FY11 forecasts, the broker sees Asciano trading at an enterprise value to earnings multiple of 9.1x while global ports are trading at 10.3x and global rail 8.9x.

In other words, Asciano is not overvalued. The broker expects management will soon provide a profit guidance upgrade.

The other stocks on Merrills' AF1 list are Commonwealth Bank ((CBA)), Computershare ((CPU)), CSL ((CSL)), Foster's ((FGL)), Lend Lease ((LLC)), MAP Group ((MAP)), Oil Search ((OSH)), Rio Tinto ((RIO)), Virgin Blue ((VBA)) and Ten Network ((TEN)).

Following on from other FNArena themes this week, Citi has upgraded its view on the media sector (GSJB Were did the same on Monday).

Last week Citi economists upgraded their 2010 GDP growth forecast from 3.5% to 4.0% and the stock analysts note that traditionally newspapers and television earnings are strongly leveraged to economic growth. Radio earnings tend to be more defensive. As a result, they have upgraded Fairfax ((FXJ)) from Hold to Buy and upgraded Ten Network forecast earnings. (Ten remains on Hold given its current share price).

PayTV names should also be benefitting, but Citi notes a lot of money is being spent on rolling out new High Definition boxes and that's impacting on current earnings. To that end the analysts prefer a cash-laden Cons Media ((CMJ)) to Austar ((AUN)) at present. Citi has a Buy on CMJ and a Hold on AUN.

JP Morgan has been travelling the country this week assessing state home building markets, and yesterday stopped into Queensland.

In the Sunshine State home builders have noted a drop-off in first home buyers post-stimulus but this has been partially offset by the return of trade-up and investment buyers. Tighter lending conditions are impacting on buyer demand but builders are also finding funding tough, such that the bigger builders are elbowing out smaller builders.

Confidence among builders is nevertheless much improved but JPM points out this is coming off a very low base. The resources sector is obviously an important driver of Queensland housing demand but this is very much a regional proposition. All up, the broker is cautiously optimistic.

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