REPEAT Rudi’s View: Valuation Support Accelerating

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FNArena editor Rudi Filapek-Vandyck shares his insights and analyses on a regular basis with paying subscribers via stories labeled 'Rudi's View'. On occasion, one of these stories is shared with non-paying members and with readers elsewhere. This is one such occasion. The story below was originally written and published on Wednesday, 24 March, 2010.

By Rudi Filapek-Vandyck, Editor FNArena

It is quite extra-ordinary what has been happening over the past few weeks, and I am not referring to the fact that equity markets (outside the US) and commodity prices are approaching new highs for the past twelve or eighteen months.

Risk appetite is back in global financial markets, there can be no doubt about it.

Is it justified? Well, that is what I was referring to in my opening sentence. As more and more economists are updating their projections on the basis of recent insights and indicators, growth projections for 2010 continue moving higher. For the US, for China, for Australia.

The only region that seems to be missing out on this global phenomenon is Europe where austerity measures by the Greek and Spanish governments are just one reason for reduced growth expectations this year.

This flood of constant upgrades is pushing up expectations for corporate profits and this, as I explained in the past, is providing global equity markets with a free bonus on the valuation side.

In other words (and this might seem strange at first sight), share markets have become relatively cheaper (thus more attractive) over the past month, even though they have risen quite strongly since the last bottom in mid-February.

Probably the best way to illustrate this is by making a straight comparison with mid-January when major Australian equity indices were at (more or less) similar levels as they are this week.

In my first editorial of the year on January 18 (still called Rudi on Thursday at the time) I calculated the average Price-Earnings (PE) multiple for the Australian share market at the time had risen to 14.5 – on fiscal 2011 estimates.

The long term average for the Australian share market is 14-15 on present year financial forecasts, not on next year's estimates. That, plus the fact that we were still eight months off from gaining updated insights about FY10 profits explains why I declared at the time that investors had once again taken their enthusiasm a few bridges too far.

We didn't have to wait long before selling pressure started to build, pulling equities down by nearly 10%.

This time around, however, we are two months closer to the end of FY10, but above all we are back at similar heights with increased valuation support. Today, the Australian share market is reflecting an average PE multiple for FY11 of around 13.7 – 0.8 lower than in January.

To put this in perspective: were the Australian share market multiple to rise again to 14.5 (similar to January) and with all else remaining equal, the ASX200 index could potentially rise to 5190.

It is this difference in valuation potential that has been supporting the share market's gradual uptrend since mid-February. Other commentators look at Greece, or at US President Obama's healthcare bill to explain why equities have risen over the past six weeks. I look at underlying valuations, knowing that the past has taught me increasing expectations tend to trigger and stimulate buying support.

That's exactly what has happened over the past month.

The good news is that this process is far from over. The offset is that the psychologically important 5000 level is approaching, and approaching fast.

Will we get through it? Probably not this week, I'd say. But if the monthly rhythm of equity market weakness into the new month repeats itself next week, I'd be inclined to say go, jump on board, because April is likely to see the ASX200 climbing above 5000.

By then, we will be another month closer to the start of FY11 and who knows how many additional expert upgrades further. It is difficult to argue with apparent valuation support.

This is also why I believe that any share market weakness will remain limited in the short term. There's simply too much valuation support for too many blue chip stocks.

Here's one way to illustrate this point: if the Australian share market is trading on 13.7 times the average Price-Earnings ratio for FY11, then how many stocks are actually trading above or below this average multiple?

FNArena's R-Factor (see website) shows 97 out of the ASX200 companies are currently trading on a lower multiple. Upmarket retailer David Jones ((DJS)) is the last one to make the cut, trading on a FY11 PER of 13.66.

If we take into account that nine of the 200 companies cannot be included because of the simple fact there are no consensus data available (yes, it's a small market in Australia) than this equals more than half the index.

The good news is that the half with below average PE-multiples includes all the banks, Big Four and the others, both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), plus the likes of Harvey Norman ((HVN)), QBE Insurance ((QBE)), Fortescue ((FMG)) -yes, you read that one correct- Incitec Pivot ((IPL)), Foster's ((FGL)) and Orica ((ORI)).

Yes, this is a rough measure to assess the market as it doesn't take into account that some stocks deserve a premium while others should trade at a discount, but surely it must be a relief to see so many blue chips, including the banks and the two diversified resources giants still on the cheaper side of the share market?!

And those two resources giants, plus Fortescue, are about to become a big deal cheaper if the latest news from Brazil about this year's iron ore pricing proves accurate.

To avoid all misinterpretations: further upgrades to corporate earnings forecasts are not solely a result of increasing pricing expectations for bulk commodities, or for commodities and energy in general.

Macquarie strategists have just finished redoing their numbers and projections for US corporate earnings and they too have responded with material upgrades. Report the strategists: “The US is undergoing a strong production-led recovery, underpinned by a very large inventory cycle, together with a still cheap currency and strong productivity growth of over 4%.”

The key factor in Macquarie's outlook is that the US consumer will not contribute materially to the jump in corporate profits. Nevertheless, earnings per share for US companies are expected to advance by 30% on average this year (calendar 2010) and again by 20% next year.

And that's just one such example.

Just for comparative reasons: earnings per share for Australian companies are currently forecast to improve by some 5%-plus in the fiscal year ending on June 30 (FY10) and by more than 20% in FY11 – these are consensus calculations done by FNArena. No doubt, this difference explains why experts believe the US market will outperform Australia.

The sceptics among you will respond by questioning whether this sudden boost of optimism doesn't smack of the good old “investor exuberance” that regularly creeps into financial markets, usually as foreplay to major disappointments later.

I note, for instance, resources analysts at Barclays issued a report today in which they proclaim we are about to witness the “biggest ever recovery in global base metals demand”. Even if this prediction proves accurate, one wonders how many investors will genuinely take this as a given and act accordingly this time around?

Just the fact that all risk assets continue to trade in close correlation with each other, centred around that elusive “risk appetite”, should indicate to everyone that just as financial markets are now caught in a self-feeding positive spiral, things could still get ugly if the global winds change direction.

But, as I indicated in stories of past weeks, these are not considerations on Mr Market's present mind.

With these thoughts I leave you all this week.

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

P.S. II – The above mentioned Macquarie market strategists made no secret about what they think lies ahead for global equity markets. The title above their strategy update carries the title “Houston – we have lift off!”

The report also highlights that key stocks in Australia with earnings exposure to the US recovery include cyclicals such as News Corp ((NWS)), James Hardie ((JHX)), Billabong ((BBG)), Incitec Pivot ((IPL)), Computershare ((CPU)) and Brambles ((BXB)), while Australian growth stocks with US exposure include CSL ((CSL)), ResMed ((RMD)), Cochlear ((COH)) and QBE Insurance ((QBE)).

P.S. III – Market strategists at Citi argued this week that the time on the so-called Investment Clock has now shifted to eight o'clock and this means that equities will turn out the best investment option this year. The Citi strategists note “The risk of a double-dip recession has faded and corporate earnings growth has started to come through”. They foresee double-digit returns for the year ahead.

P.S. IV – Market strategists at Deutsche Bank have done some extra-work into which sectors and companies in Australia are more leveraged to the economic recovery than others. Their conclusion is that the operating leverage might not be great in areas exposed to household spending, but it continues to look potentially large where business spending is involved. As such, the strategists added Leighton ((LEI)) and Goodman Group ((GMG)) to their Model Portfolio, replacing Crown ((CWN)) and Mirvac ((MGR)).

P.S. V – Following on from my Weekly Insights on Monday (see “Nickel, The Leader Of The Pack?”), here's the list of ASX-listed exposures to nickel I promised:

(in no particular order)

Mirabela Nickel ((MBN))

Independence Group ((IGO))

Metallica Minerals ((MLM))

Fox Resource ((FXR))

GME Resource ((GME))

Falcon Minerals ((FCN))

Segue Resources ((SEG))

Mincor Resources ((MCR))

Minara Resources ((MRE))

Panoramic Resources ((PAN))

Western Areas ((WSA))

Tectonic Resources ((TTR))

Heron Resources ((HRR))

Poseidon Nickel ((POS))

P.S. VI – Those who have missed my recent analyses are invited to also read:

Weekly Insights: Nickel, The Leader Of The Pack?

Weekly Insights: Counting Market Headwinds

Rudi's View: Towards A New High For The Year?

Weekly Insights: Between Cheap And Fully Valued

Weekly Insights: How “Good” Was The February Reporting Season?

Weekly Insights: How Much Should Investors Pay?

Weekly Insights: Lessons From 1994

Weekly Insights: History Shows No Great Return For Year Zero

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