Earnings Downgrades To Drive Further Weakness?

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By Chris Shaw

Over the past couple of weeks there has been an escalation of tension in the Korean Peninsula, further bank and credit problems in Europe and an apparent weakening of momentum in US leading economic indicators. Citi notes an increased level of despair in the global investment community.

At the same time, Citi notes some in the US market are trying to call a bottom, which implies the current bad news appears to be starting to be priced into equity markets. Valuation is certainly looking better but this doesn't usually signal an imminent rebound, Citi pointing out valuation is a necessary but insufficient condition to turn the tide of the market on its own.

Uncertainty remains an issue for GSJB Were, thanks to factors such as the proposed RSPT in Australia and sentiment flows surrounding China, though Citi's commodity analysts suggest the latest data indicates speculators have been taking profits but not aggressively shorting metal markets during recent turmoil.

There are reasons for this, as Citi points out demand indicators for developed economies remain robust, even in Europe, which should support commodity demand. As well, it suggests in China the concerns over the possible impact of a slowing in the housing market may also be overstated as housing accounts for only 10-15% of base metals demand.

With the increase in risk aversion, GSJB Were notes investors have temporarily shifted back to more defensive names, which also reflects concerns over the potential for earnings downgrades to increase as the focus shifts to FY11.

Such downgrades in the US are likely according to Citi, as the analysts take the view a trimming of earnings estimates for 2011 in particular still needs to be addressed. In other words, the upward earnings estimate revision trend needs to pull back from current levels. This process would create a setting from which an equity rally can be more sustainable.

As Citi notes, the market overall does appear reasonable value, as various analysis tools suggest equities are tending towards cheap at current levels. As an example the broker points to its highly correlated trailing P/E to bond yields and equity risk premium model, which currently implies the US S&P500 is more than 25% undervalued.

In Australia, Citi estimates earnings are currently around 17% below trend or “mid-cycle” levels, which reflects the 30% fall in earnings between February of 2008 and September of 2009. Given this, the broker suggests if global macro risk concerns weaken from current elevated levels the market would be entering a downturn with an earnings base with less downside risk.

The important point here is this would be in stark contrast to the 2008/09 recession, as at that time the earnings backdrop was one of peak cycle numbers that gave scope for massive cuts to estimates. On Citi's forecasts Australian equities should deliver 27% earnings growth in 2011 while consensus numbers suggest growth of around 25%.

Even if no earnings growth is delivered over the next 12 months, Citi estimates valuations on the market would be no higher than the long-run average of about 14.8 times earnings. This means for the market to start looking expensive earnings next year would now need to be downgraded by around 30%.

If only half the forecast earnings growth over the next year is achieved, which implies growth in earnings of 12.5%, the Australian market's forward price to earnings ratio would still only rise to 13.2 times. Citi regards this as still cheap relative to long-term historical averages.

The 800-pound gorilla is that equity market valuations also appeared cheap in September of 2008, just prior to the collapse of Lehman Brothers. This time around the issue is sovereign debt but rather than a sharp collapse, Citi sees this as a slow bleed issue, meaning it will be a headwind for equities through the next decade.

But for equities to take a another significant downward leg Citi suggests it would require a complete capitulation in all forms of confidence, something that would lead to massive earnings downgrades. But as such an extreme shock event is unlikely in the analysts' view it follows that equity market prices at present represent great value rather than a value trap.

Medium-term there are a number of factors Citi sees as supportive to earnings growth, including ongoing solid population growth, lower corporate gearing levels and an expectation of ongoing improvement in Australia's terms of trade.

These also supports the broker's view the Australian market offers value at current levels.

Given current market conditions and expectations GSJB Were's model portfolio is currently overweight the Materials, Commercial Services, Transport, Media and Retail sectors, while the broker is underweight the Banks, Insurance, REITs, Healthcare, Consumer Staples and Utilities sectors.

With respect to specific stock positions GSJB Were has its five largest overweight positions in ANZ Banking Group (( ANZ)), Wesfarmers ((WES)), National Australia Bank ((NAB)), News Corporation ((NWS)) and Qantas ((QAN)).

Its five largest underweight positions are Commonwealth Bank ((CBA)), Telstra ((TLS)), Woolworths ((WOW)), Westfield ((WDC)) and QBE Insurance ((QBE)).

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