The Importance Of Earnings Certainty

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(This story was sent to paying subscribers in the form of an email on Monday).

By Rudi Filapek-Vandyck, Editor FNArena

Here's for an easy prediction to make: unless earnings forecasts start rising at some point, the October month rally for global equities will not prove sustainable.

Analysis by Macquarie has revealed the correlation between the performance of equities and changes in forecasts by stockbroking analysts has become increasingly stronger in recent years, yet sometimes other factors dominate investors' focus. In October all that mattered was that equities looked cheap, European leaders finally put a plan together and economic data in the US and in China surprised to the upside after months of underwhelming. The combination allowed for one of the best October month performances ever for equity markets across the world.

All the talk among stockbrokers and hopeful investors is whether cashed up funds managers are becoming nervous enough about their performance figures at year end? If so, this may well trigger a come-back into equities and thus cause a big rally. It would be a welcome relief after a year that failed to live up to expectations on so many accounts. US equities are now back in positive territory for calendar 2011, but the Australian share market is still down a few percentages. BHP Billiton ((BHP)) shares are down 16% since early January. CommBank ((CBA)) shares are almost flat for the year. Newcrest ((NCM)) shares are down more than 16%. Shares in Woodside Petroleum ((WPL)) still have to catch up close to 12%.

Corporate earnings forecasts started trending south again in July, on a global scale, and they have remained in a negative trend since. Virtually every expert seems to agree more cuts and downgrades remain on the agenda as global economic forecasts have weakened in the weeks past and that puts downward pressure on what individual companies can achieve in terms of margin expansion and sales. The implied margin expansions for industrial companies the world around in particular is receiving quite some attention (and criticism), but there are plenty of question marks for other sectors too, including producers of natural resources.

The fact that global earnings forecasts made a concerted dive into negative territory in July has experts worried. Analysts at UBS and Macquarie, for example, believe a new "downcycle" has started in earnings forecasts. This is not unimportant as the past years have shown that upcycles and downcycles in these forecasts support similar moves in equity prices. Unsurprisingly, the last up-cycle took off in 2009, weakened in 2010 but improved in the second half of last year until May. Making matters worse, both UBS and Macquarie believe the early stages in such a downcycle are the worst for equity performances.

On historical evidence, and assuming all else remains equal, investors should not expect more than single digit returns from the Australian share market in the year ahead, predict both UBS and Macquarie. The good news about this historical forecast is that the ASX200 is today circa 6% below where it was in early July (4600) when this latest downcycle started. This means that on pure statistical form, the index can gain double digits in the next nine months and still remain inside the boundaries as suggested by historical precedents.

The other good news is that the next stage in the cycle will be the best one to enter the share market, generating on average the highest returns, all else being equal. Historical analysis clearly shows that when earnings forecasts are negative and falling (is the case since July), this is usually the worst time to buy into equities. However, when earnings forecasts are still negative but they start turning the corner, which will be the next phase in the cycle, this tends to be the best time to be in equities, generating close to double digits on average in the year ahead.

All this assumes the close correlation between earnings forecasts and the performance of equities as has been in existence throughout the first decade of this century remains intact. (Note: Macquarie research has generated slightly different numbers, but still similar to UBS's thus confirming the underlying thesis).

Of course, nothing is ever set in stone in the world of finance and investing. What could change the course of earnings expectations? Another round of Quantitative Easing in the US could, and some experts believe we may see QE3 back on the agenda as early as Q1 next year. A new stimulus program in China could shake up things as well, though this is at present not anticipated by anyone. A much better performance of economies in the US, Europe and in China could make a big difference too. Last but not least, big movements in FX markets can have a pronounced impact too, but mostly in a negative sense outside the US if these moves are based upon a weakening USD.

Let's for now stick to the script as suggested by Macquarie and UBS (and others), implying we will see continued cuts to forecasts in the months ahead. Conclusion number one is this will erode the potential upside for equities. Certainly, recent updates of investment returns by local stockbrokerages fall in line with this suggestion.

On Monday, market strategists at Goldman Sachs updated their projections for the ASX200 amidst a much better environment for risk appetite, now that European leaders have averted worst case scenarios. Even so, I am certain Goldmans' revised targets will be a disappointment to many a hopeful investor. The new target for the ASX200 by late December this year sits at 4375. The index closed at 4298 on Monday. Targets for June next year (4800) and for December 2012 (4850) suggest double digit returns should be possible, but not in a spectacular fashion.

Note there is no suggestion of a return to 5000 anytime soon.

Last week, market strategists at JP Morgan set their ASX200 target at 4250 for year-end and at 4600 for June next year. Unsurprisingly, JP Morgan finds it hard to locate genuine bargains in the share market, while arguing that margins will increasingly come under pressure for mining and energy companies too and this will translate into less upside potential than may be assumed by investors. Further adding to miners' reduced potential, JPM reports "there is little disagreement that commodity prices will be lower one day and even in optimistic markets the stocks are valued accordingly. The swing factor for the valuation debate is whether the fade assumption is too optimistic because there will be a rout."

It for this reason, and because the RBA is likely to provide some relief, that JP Morgan strategists like "domestic" risk rather than international risks in the Australian share market. A view seemingly backed by strategists at Credit Suisse who stated in their market update on Monday they remain overweight discretionary retail and banks, and underweight resources.

So how is the Australian share market positioned at this stage?

It has to be noted rating downgrades by stockbrokers have been outnumbering upgrades for several weeks now. The week past, for example, saw 25 downgrades against 11 upgrades suggesting more and more equities are becoming less attractive from a fundamental (value) view point, despite the index still being in negative territory for the year.

As far as earnings forecasts are concerned, on FNArena's consensus forecasts for members of the ASX200, corrected for outliers and excluding the six banks, stockbroker analysts are already projecting less than 5% growth only for FY12. While this number is expected to more than double in FY13 (up 13.8%) there are still many question marks about whether this will prove rather wishful thinking or not. Investors should note there's a clearly visible downtrend in earnings estimates for banks as well as for large resources companies, with most companies concerned coming from elevated growth numbers in years past (not expected to be repeated in the years ahead).

Having said so, National Australia Bank's ((NAB)) FY11 results surprised to the upside last week and earnings forecasts as well as price targets went up after the event. Note that NAB is anticipated to grow more firmly than others in the year ahead, with exception of Bank of Queensland ((BOQ)) whose potential growth this year is set at no less than 44%, but questions about asset quality and bad loans are keeping investors away nevertheless.

On an individual basis there are, of course, plenty of companies whose growth will exceed the market's average in the year(s) ahead. Investors will have to pay close attention to two critical points: is that growth potential already reflected in the share price? Plus what are the chances that growth expectations might not be met?

The latter factor in particular is seen as a key danger by analysts at UBS and Macquarie when picking stocks for the year ahead: what are the chances growth expectations will not be achieved? Both brokers suggest investors pay close attention to how much of the anticipated growth is dependent on expanding margins. That's where the major risks lie right now, they suggest.

Most at risk, suggests Macquarie, are companies such as Leighton Holdings ((LEI)), BlueScope Steel ((BSL)), Aristocrat Leisure ((ALL)) and Suncorp ((SUN)), alongside resources plays Energy Resources of Australia ((ERA)), Iluka ((ILU)), Whitehaven Coal ((WHC)), Fortescue Metals ((FMG)), Mount Gibson ((MGX)) and QR National ((QRN)). Investors will have to weigh up the potential rewards against the potential punishment that will follow in case present margin assumptions prove too rosy in the months ahead.

Also, it is not difficult to see why the ten stocks I selected for the FNArena Investment Quiz a few weeks ago have outperformed the share market post 2007. All companies involved achieved consistent growth, at seemingly low risk and with no nasty surprises.

(This story was originally written on Monday, 31 October 2011. It was sent out in the form of an email to paying subscribers on that day.)

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