FYI | Feb 08 2013
By Greg Peel
“Sell in May and go away,” that is the well-worn adage. It worked in 2012, and in 2011, and in 2010, albeit not necessarily in May per se. It didn’t happen in 2009, but then 2009 was the initial bounce out of 2008, which was by no means a usual sort of year. Will it happen in 2013?
Does anyone remember the number 6828? Anyone who bought at this level probably still has nightmares. It was the November 2007, and thus all-time, high in the ASX 200. The next number to recall is 3145, which was the March 2009 GFC low, representing a 54% retracement. If I glance up at the screen while writing, we are currently at 4935. From the bottom up, that’s a 57% rally, with another 38% to go to get to that 2007 high. By contrast, the S&P 500 (US broad market analogue to the ASX 200) requires only another 3.5% to reach its all-time high.
Of course the US has QE, and all Australia has are a few half-hearted rate cuts. The RBA pumped rates up in 2008.
The point is that the 57% rally of four years is quite a reasonable return (and that’s before dividends!) so the whole “sell in May” thing is something the sensible longer term investor could choose to just scoff at. That is, of course, if that investor had such nerves of steel that the subsequent corrections in that rally in each year since, related to serious macro concerns such as the fall of the eurozone, a hard landing for China, a double-dip recession for the US et al, washed off like water of the proverbial duck.
Most real people are still hiding behind the couch, state of mind completely shot since 2008. On more than one occasion they have plucked up the courage to come out as far as the lounge room rug, only to go diving back behind the couch again at every new “sell in May” correction. Most real people still have their money in term deposits, at ever diminishing yields.
Funnily enough, the whole “sell in May” thing is a US adage which initially related to little more than the tendency for investors to close out positions ahead of the summer holidays so they could actually relax, before reopening them again in the spring. It’s all about the weather, not a Greek exit.
The adage has taken on a new life and is often the case in markets, “sell in May” is really now “sell in April” for the purpose of getting ahead of the “sell in May” crowd. Or sell in March and put up with missing the last of the rally that started on November. In other words,it’s all a crock.
In a similar vein, the “Santa rally” has taken on a new life of its own. Once upon a time US fund managers would enjoy their Christmas dinner, and return to work for that final week of the year ready to push up stock prices as a last ditch effort to improve calendar year returns. Thus stocks rallied for one week, and this rally was deemed to have been brought by Santa.
Today, the famed “Santa rally” tends to start around late October and last as long as March. These rallies have pretty much occurred in 2012, and 2011, and 2010, and even 2009. The reason for this has absolutely nothing to do with tradition, but it does have a lot to do with Santa. That is, if you picture a Ben Bernanke in jolly red suit. QE1, QE2, QE2.5 (Operation Twist) and QE3 were all flagged at the Fed’s annual meeting at Jackson Hole in late August, and confirmed about a month later. Cue the rally.
This latest “Santa rally”, if that’s what we can still call it, has seen global equities rally more than a net 20% in six months, on UBS numbers. As a longer term investor, a 20% equity return over two years would be considered a fabulous return. But markets, as anyone will tell you, can never go up in a straight line forever. Pullbacks are ubiquitous, and considered healthy. Even “corrections” (assuming the 10% rule, which is just a load of semantics) are not the stuff of concern. The problem, at least speaking in trader terms, is picking the actual timing.
Longer term investors should not at all care. That is, unless they are not yet “in”. If they’re still “on the sidelines”, then an agonising decision needs to be made. Do I buy now, or wait for the pullback which must come? How much of a pullback will it be? Might it still not happen for another 10-20% up and then I’m even more of a Loser? Will I be that famous guy – the last one in any herd who pays the top price and “rings the bell” for the pullback to commence?
Market commentators across the globe are currently talking about little else. Pullback, or no pullback at this time. It’s only February – a good three months before May – so maybe the time is not yet night. Others, who do not subscribe to such mythology, will tell you a pullback will come only when no one is ready.
Which is one of the arguments as to why a pullback may not happen just yet: everyone’s ready for one. Let’s look at the arguments on both sides:
The argument for a pullback: the market has run 20%, thus a pullback is overdue; trading volumes have not really improved much, so there is little weight behind the rally; PE ratios have shot up quickly with little or no outlook for improving earnings to support higher prices; Europe has not gone away.
The argument against: sheer weight of global easy money; sheer weight of cash still “on the sidelines” but now trickling back; PEs are not high by historical standards; everyone is expecting a pullback; everyone is waiting for a pullback in order to get in, reducing any pullback magnitude potential; Europe is under control.
So what do the analysts at the big investment banks think?
Deutsche Bank notes that global economic growth looks to be “on the mend”. The global PMI (an aggregate of all the manufacturing and non-manufacturing purchasing managers’ indices across major economies) is rising, and the extent of company earnings revisions is becoming less negative (meaning forecast earnings downgrades are becoming fewer and of less magnitude). All of the above justifies a rally in equities. Except, as Deutsche suggests, that equities started pricing in such positivity long before it was ever confirmed. We already had the rally.
The tail of this rally is thus potentially all about the overexcited herd, not to try to put words in Deutsche’s mouth. The analysts note that we are no longer seeing better than expected data releases out of the likes of the US and China, as we did in the second half of 2012, and indeed if anything recent releases have been a little weak. Deutsche notes that there were similar occasions in both 2010 and 2011 in which the data turned down after equities had run up, and they both resulted in pullbacks (both around 16% in the S&P 500).
Singling out Australia, Deutsche notes domestic earnings remain under a lot more pressure than is the case offshore. Yet we’ve actually outperformed the US in 2013. The reason for this is the re-rating in PEs.
Strictly a price/earnings ratio (PE) measures the multiple of one year’s corporate earnings reflected in the price of the shares. Realistically a PE is a sentiment index. The market does not wait to learn a company’s earnings before deciding whether to buy the shares, the market builds anticipation of earnings into the share price. And one year is not an investment time horizon — we invest in the hope of many years of earnings to come.
If earnings are expected to be low and sentiment is low, PEs will be low (eg March 2009). If earnings are expected to be high and sentiment is high, PEs will be high (eg October 2007). At some point they get too low and at some point too high, which is when the herd is in play at the extremes. But because the market anticipates, rather than responds, PEs will shift back towards the average long before earnings catch up. It’s all about sentiment. Right now, sentiment is positive.
Indeed, the Australian market PE is now back around the long term average. This would imply that PEs are not yet too high. However, as Deutsche notes, Australian PEs have re-rated very quickly, and are up 31% in six months compared to a global average re-rating of 17%.
Over the past 25 years, Deutsche points out, there have been eight instances in which PEs have re-rated more than 15% in a six-month period. On average, each of those moves was followed by a market pause before a further 6-7% PE increase in the following year. In this episode, we have had no pause.
We know what any stock’s “P” is at the moment, and we’re about to find out more definitive information on “E” as the six month earnings result season unfolds. PEs might only be back to average but this is enough for Deutsche to shy away from calling any further rise. An immediate earnings bounce is “not obvious to us,” say the analysts.
Deutsche is not alone. The recent count of stock rating (Buy/Hold/Sell) downgrades to upgrades in the FNArena database is two to one. And earnings season is only now starting. Even before the results, eight leading stock brokers have decided, on a net basis, that there is a lot of overpricing (too high PEs) in this market.
Maybe UBS’ fund manager clients know something. They started buying equities last year, and were still net buying in the early weeks of 2013. Over the past two weeks however, those clients have become net sellers, UBS reports. The UBS analysts are anything but surprised. And their “tactical indicators” are also close to “overbought” territory.
Further breaking down the sample set, UBS notes that its “long only” clients (longer term “investors” such as super funds) have net bought in nine of the last thirteen weeks, while hedge funds (long and/or short “traders” on short time horizons) have net sold in the last eight of ten weeks.
Even Europe has been in on the equity buying act, driven, Citi notes, by very strong (aforementioned) PMIs and business confidence surveys coming out of Germany. Recent data, however, have proven “less positive”, suggesting to Citi that momentum is waning. This fits in with Deutsche's global observations.
What is Citi’s recommendation then?
“Despite our willingness to take on longer term value exposure [in Europe] from a macroeconomic perspective and the positive view on equities from our strategists, we question whether the current rally is sustainable without some form of short term retracement of performance”.
Coming back to Australia, Credit Suisse likes to look at “broad market valuations” when selecting which asset classes, sectors and stocks to invest in. These include market PE, the ratio of bond yield to equity (dividend) yield, real estate investment trusts (REIT) versus bonds, and small stocks versus large stocks. Having done so, these are Credit Suisse’s conclusions:
US equities still look “slightly cheap” on a PE basis. Australian equities look “slightly expensive”. Within Australia, industrials ex-financials look expensive and resources look slightly expensive. Yield stocks (including REITs and banks) “do not offer compelling value relative to other sectors”.
So where does this all lead us. From the longer term investor’s point of view, if you’re long already, a pullback is little to fear in the wider scheme. If you’re not long, but feel you might be missing out, your chance may yet come. The longer it doesn’t, the more likely the eventual pullback will be a little more significant. You are not, however, going to get much return on investment joy from cash or riskless fixed income from here, particularly net of inflation.
And perhaps most importantly, anyone who, in retrospect, “misses” the beginning of what proves to be one of history’s great bull markets, has only “missed” just that – the beginning. The most successful investors let others pick bottoms and wait for more compelling evidence.
But there are no guarantees we are as yet seeing a definitive bull market.
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