Back To 2009?

This story features TELSTRA GROUP LIMITED. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

Two weeks ago I calculated how, on some measurements at least, the long-term average return for the Australian share market had fallen back towards a level last seen in early 2009. Combine this with the observation that Price-Earnings ratios (PEs) in late 2010 were also at unusually low levels and it is not difficult to see as to why some market experts are predicting 30-40% gains for equities this year, with ongoing positive surprise potential.

In 2009 the ASX200 rallied some 55% from the bottom in March to the peak in October, which lasted no more than five months. How realistic is it to expect something similar in 2012?

Let's start by lining up some obvious parallels between the share market today and the situation three years ago:

– in both cases the preceding year proved disappointing for investors, though the losses incurred last year are much smaller than those in 2008
– on average, valuations are below historical norm (though again, today's are not as cheap as in 2009)
– economic data and leading global indicators are turning the corner (they did so from much lower levels in 2009)
– there's an unusually large amount of cash sitting in deposits and bonds
– the initial trigger of the upswing appears to have been caused by short-covering and portfolio reshuffling; in 2009 it was all about US banks, this year the key words have been commodities and cyclicals
– central banks around the world are providing extra-liquidity

Remember that last point as it doesn't receive as much attention as the first four points mentioned, but it might well become the most important supportive factor behind all positive scenarios this year. Let's leave it aside for now, I'll get back onto it.

Let's look into some of the obvious discrepancies:

– economic data might have turned a corner, but the global debt problem remains unresolved and Europe is still facing a recession, increased austerity and potentially a credit crunch
– there's another important and easily to identify factor behind better-than-expected economic data; unusually mild weather until late January compared with an extremely cold winter the previous year (it looks like this is "normalising" this month)
– securities analysts are much more on the ball and in touch with reality this time around compared with 2009 when they had absolutely no clue and their estimates reflected exactly that (estimates today are probably still too high though)
– investors have become much more wary. In 2009 there quickly was a general feeling of "that was that, now let's move on". This year nobody seems to be participating (see ever declining trading volumes and FNArena's Investor Sentiment Survey in January)
– ever declining transaction volumes and growing importance of robots and high frequency trading has arguably made Mr Market more of an ice-cold, knee-jerk trader these days rather than a sophisticated long-term investor

Admittedly, the latter two points can potentially change instantly as, in line with my personal market observation throughout the years, nothing else can be as seductive as rising share prices. All that would need to happen to get this market into full steam ahead mode again is for indices to break outside of their established ranges, to get the traders on board with extra conviction, and increased clarity about a constructive way forward in Europe, to get some of that cash on the sidelines back into equities.

As far as "cash on the sidelines" is concerned, analysts at Citi recently calculated corporates in the US have now amassed a good US$2trn (that is trillion, as in 2000 billion) in cash and all that liquidity is pretty much doing nothing at the moment. In addition, calculated these analysts, US households' deposits carry some US$8trn. Both numbers compare with a total S&P market capitalisation of USD12.5trn, suggesting any change in dynamic here can have some significant consequences for risk assets.

Incidentally, let's not forget about the negative trend among retiring baby boomers whose gradual, generational exit from equities and other high risk opportunities will not reverse until a good ten years from now. (FNArena was being reminded about this fact by many a respondent in aforementioned Investor Sentiment Survey).

Forget about "cash on the sidelines", the real market mover will come from existing portfolios and market positions. Equity allocations at global funds managers have not been as low for decades and various auctions of short term sovereign debt still result in investors paying more than they will ever be able to on-sell these governments bonds for. Changes in this dynamic will be the real litmus test to see whether equities can regain their place of favourite investment destination, even if it's only temporarily, like in 2009.

Thus far, such a switch out of bonds and other yield assets into higher risk, non-yielding equities is not happening. Note A-REITs as a sector outperformed the broader share market in January. Telstra ((TLS)), with an 8.3% dividend yield, is still bid. In addition, funeral service provider InvoCare ((IVC)), which must be close to being the ultimate safe haven in Australia (up 45% since early 2010 and currently still carrying a 3.8% dividend yield despite a PE of 22) continues to attract buyers. The share price again surged above consensus price target on Monday.

The global investment community remains extremely defensively positioned, so any changes in portfolio allocations can have a significant impact on prices for riskier assets, but so far there's little evidence (if any) this is happening.

Even without any of the cash on the sidelines or portfolio re-positionings occurring, I still believe 2012 has the potential to become "Opposite Year", whereby everything that failed so miserably last year is more likely to turn a profit this year, while all the defensives that proved their might in 2010 and in 2011 temporarily risk being left behind. As I have pointed out since October last year, defensive assets look fully valued, while higher risk, cyclical assets look extremely cheap. This is the dynamic that set the positive momentum in motion at the start of the year, it is this dynamic that can potentially colour (most of) 2012.

Risk assets are also being supported by political elections and changes in leadership taking place this year in many countries including the US and China. This means much of the government belt tightening that is inevitably on the agenda will likely be pushed out to late this year, or into 2013.

The biggest support this year, in my view, comes from the fact that major central banks have all started to provide excess liquidity, and this will remain one of the stand-out features in 2012. It has been a while since the world (and financial assets) enjoyed synchronised monetary stimulus from all the leading central banks in the world, but this year the liquidity taps are open in London, New York, Brussels, Tokyo and Beijing. As shown in the chart below (thanks to Citi), this is one big stimulus boost that 2012 shares with 2009. At the very least, this should put a bottom under risk assets this year. Under the most optimistic scenario, this could fuel another Big Rally in risk this year.

As we digest all this, how realistic are predictions of 30-40% gains for equities this year?

At face value, such predictions seem out of touch with the fact the average PE for the ASX200 right now sits at 13.7 for FY12 and at 12.6 for FY13. Even if we dismiss FY12 and simply focus on FY13 (as investors will do if this rally continues, which would be another similarity with 2009) plus we assume that projected growth in earnings per share next year (not this year) of more than 17% is accurate and we re-rate back to an average PE of 14, the maths still don't reach higher than 4800 (circa 11.5% from today's levels, ex dividends and on top of the gains made so far).

However, this general approach neglects the fact that undervalued cyclicals can re-value much higher from single-digit PEs, while a subsequent de-rating of highly valued defensives would provide the offset. (Something investors this year should keep in mind).

I still don't think we're ready to cross over the 5000 mark anytime soon, especially not since I also expect that limitations to economic and earnings growth, and thus to share prices, will re-announce themselves at some stage. If, for some miraculous reason, that doesn't happen between now and December, it'll happen in 2013.

Until then, investors are likely to zoom in on forward looking statements and guidance during this month's reporting season.

(This story was originally written on Monday, 6th February 2012. It was published on the day in the form of an email to paying subscribers).

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