Australia | Oct 18 2012
– ASX 200 rising on PE expansion
– Earnings forecasts continue to weaken
– low bond yields increase stock attraction
– Bull market or dangerous path?
By Greg Peel
At the end of the day stock valuations are driven by a combination of two factors – reality and perception. To gauge reality we have company earnings results, which are forecast into time, and to gauge perception we have price/earnings multiples. If company earnings are held static but prices rise, this indicates a higher PE. A higher PE can be driven only by improving sentiment.
Markets don't wait around to see earnings confirmed before PEs are pushed higher. Investors responsible for a rally's source are taking the punt earnings will improve down the track, reflecting improving economic conditions, to so justify the early mover's bullish anticipation. Only if the rally gains traction will the herd jump on, and the herd ultimately becomes responsible for pushing sentiment beyond reality.
The ASX 200 has risen 13% since the June low. Deutsche Bank noted last week that the index PE ratio had risen from 10.7x to 12.7x, or 18%, since end-May. Over that period, forward earnings forecasts have fallen 8%, yet the market PE is now closer to its ten-year average than its two-year average. Sentiment has grown despite falling earnings expectations and despite weak global growth and a lack of any satisfactory solution for Europe. The impact of global monetary stimulus and the abatement of negative data surprises have “clearly been substantial,” Deutsche concludes.
Deutsche also notes, and regular followers of FNArena's Weekly Recommendation Changes series published each Monday will be fully aware, that the ratio of analyst stock rating downgrades to upgrades has been running at around two to one since early 2011. The general view is of a necessity for policy responses from China and Australia in order to put a floor under falling earnings expectations, but while the RBA seems to have finally begun to rally to the cause the PBoC has only fiddled about the edges.
“For the rally to be sustained,” suggests Deutsche, “sustained earnings growth needs to come through at some point and this looks unlikely to happen in the near-term”.
It is not often Australia's stock analysts and strategists fall into line on a market view, but it appears just about all major houses are in agreement with Deutsche.
UBS has edged up its own year-end PE target for the ASX 200 to 13.0x from 12.5x. However, “we are reluctant to expand our target PE further at this point given the sluggish global macroeconomic environment and tough economic backdrop”.
Macquarie also notes recent PE expansion has been “in the absence of a strong recovery in earnings”, and Morgan Stanley's Gerard Minack has gone as far as to admit “we have been too bearish equities this year”. Minack presumes PEs are up when earnings are down only because of the power of central bank policy, and as such “the prospect of ongoing policy intervention would be a powerful bull point for stocks”.
However at new, higher PE levels, and with downside risk to earnings, Morgan Stanley doubts that the equity rally, at least for developed markets, will persist into next year.
If one multiplies PE by forecast ASX 200 earnings one arrives at an index target for the period chosen. (Price/earnings x earnings = price). Different analysts have different earnings forecasts, and as such Macquarie has the ASX 200 finishing the year at 4542 (it's 4575 intra-day today) and Deutsche at 4600. These numbers are still a long way from the major resistance level of 5000, which represents the 2008 break-down level and the concrete roof of 2009-10 rallies.
From the global perspective, Citi also concurs with earnings warnings but is prepared to back the power of central banks. “The bad news for global equities,” says Citi, “is that profits are slowing around the world and EPS expectations need to be cut further. In our view the current downgrade cycle is not over”. However, “The good news is that equity valuations [PE] remain cheap and central banks are prepared to embark on additional easing”.
Citi thus has Overweight ratings on the US, Australia and Asia (ex-Japan), with an Underweight on Japan and an “Avoid” on Europe.
Does this put Citi at odds with Deutsche, UBS, Macquarie and Morgan Stanley?
Well, UBS is prepared to justify the seeming contradiction of strengthening PEs in the face of ever weakening earnings forecasts by considering another element of stock market valuation – the gap between stock yields and bond yields.
As we are now well aware, the Australian stocks which have driven the rally from June (and indeed those stocks which have outperformed index weakness over the past two years or more) are those stocks offering investors with a yield alternative. These include traditional defensives such as cashflow businesses (eg supermarkets) and utilities (eg pipelines) but also less defensive industrials which simply offer high but relatively consistent yields (eg mining contractors).
Yield has been “rediscovered” since the GFC, once investors were shocked into realising that stock prices do not just go up forever and that income cannot be guaranteed from capital growth alone. Exacerbating the newfound search for yield has been the simultaneous drop in fixed income yields as a result of historically low global interest rates. Negative real yields are as good a reason to look to stocks for income as any other. If we consider central bank policy as being the most influential driver of market sentiment, we can look at it less sentimentally by suggesting negative real fixed income returns have forced investors into stocks.
In Australia, bank competition has provided very healthy term deposit rates to help keep would-be investors away from the stock market but those rates are now on the decline with central bank easing, and government bond rates are offering very little real yield.
The “relative value versus bonds” argument, notes UBS, has for some time been the bull case for the stock market and “there are signs this thesis is building some momentum”, as evidence by the recent performance of “yield sectors”. If we compare Australia to the US, Australia's market is considered “yield heavy” despite the big chunk of low dividend paying resources market cap. And if the RBA keeps cutting its cash rate into 2013, as money markets are anticipating, then “this may provide a surprisingly bullish backdrop” for the Australian market.
It is rather scarily incongruous. In Australia we have a government now completely disconnected from any concepts of economic management as it tightens the fiscal budget further and further for the singular purpose of self-preservation following a foolish “promise”, forcing the central bank to respond to a slowing economy by easing monetary policy to historically low levels. The slowing economy is well evidenced by ever falling corporate earnings forecasts. Yet the stock market is on a tear, pushing up valuations on pure sentiment through either income preservation necessity or questionable faith in the power of the global printing press.
If newfound sentiment levels are right, and that would mean QE3 successfully reducing US unemployment, Europe getting its house in order with ECB intervention and China finally turning on the policy taps, then today's bulls will be proven justifiably prescient.
Or it could all end in tears. While it takes both bulls and bears to make a market, one must say the two camps are currently very polarised.
Respected analyst and daily correspondent Richard Coppelson from Goldman Sachs thinks 2012 is beginning to look a lot like 2003, chart-wise.
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