Equity Strategy: Can The Bull Market Just Keep Going?

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This story features ORIGIN ENERGY LIMITED, and other companies.
For more info SHARE ANALYSIS: ORG
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Of all the arguments commentators can come up with as the why equity markets, and in particular the US equity market, must be shortly due for a correction, the most popular is that a correction is “overdue”. But a correction has been “overdue” for about two years now, and Wall Street keeps establishing new record highs. Fear of a correction, or hoping one will transpire to allow entry into equities at more reasonable prices, has kept many out of the market, and thus out of pocket.

If we bow to the accepted, yet meaningless, definitions of a 10% pullback equating to a correction and a 20% pullback equating to a bear market, we note that not only is a correction overdue since mid-2011, there has been no bear market since the big one which began in late 2007 and bottomed in March 2009. A three-year run without a correction and a five-year run without a bear market both exceed historical averages. But then we must remember that such averages include both shorter and longer individual runs than we have seen to 2014 so far.

History does tell us, nevertheless, that corrections rarely occur because they were expected, and are never triggered by something everyone was anticipating. The level of panic required to achieve correction implies investors were caught out by something they did not anticipate at all, and usually when least expected. There are always those wise after the event, of course, or those who had warned of a correction for so long they were always going to be right one day, although by that stage broke.

Often corrections occur for no readily apparent or definitive reason. The buying just stops.

And typical of any correction is the involvement of the vascillating retail investor – specifically the Johnny-come-latelies who ultimately take a bull market into its recognised third, or “exuberance” stage. Since 2010, commentators have been noting the lack of retail investor participation in the rally, and still are. Hence the rally is commonly described as “unloved”. To reach the “exuberance” stage, a market first needs some lovin’.

Yet still we see growing trepidation at new highs, from both those already in the market holding paper profits, who fear a pullback is nigh, and those not in the market who have missed out to date and would love to get in, but fear a pullback is nigh. We have also seen, in 2014 alone, a handful of what would once have been classic pullback triggers that no one saw coming: Ukraine, Iraq and most recently a Portuguese bank defaulting on a debt payment have all been contenders. These were afforded no more than a blip of nervousness, primarily because there is a queue of investors ready to get in on any sign of a pullback, and plenty of those are prepared to be queue-jumpers.

To suggest the S&P 500 bull market run from 2009 is now looking “old”, and thus a substantial pullback must occur anytime now, is to imply, suggest Citi’s US equity strategists, “that record earnings, significant stock buyback activity and unprecedented global central bank easing has no impact either” and to ignore that “some rallies can last longer than traditional averages”.

On the subject of central banks, clearly the most commonly cited potential trigger of a pullback at present is a Fed rate rise, or at least some confirmation a Fed rate rise is on the cards. Yet we recall that (a) corrections are never triggered by something everyone expects, (b) if a rate rise is such a concern presumably we would have begun correcting by now, and (c) everyone said the same about Fed tapering but when tapering was finally confirmed, in December last year, the Dow rallied 200 points on the day and has barely looked back.

Nevertheless, Citi suggests “it is reasonable to consider a Fed policy shift as being the potential crack in the investment story, though history suggests that earnings can compensate for rates as long as tight monetary policy does not emerge”.

What Citi is saying is that an interest rise by default is not an equity killer. To appreciate this one has to consider the “neutral” (also called “normal”) cash rate. Any cash rate below neutral implies “loose” monetary policy, which also implies a degree of tightening is required before policy becomes “tight”, that is, above neutral. Policy has never been as loose as zero plus QE in the US or 2.5% in Australia in history. There are plenty of rate rises ahead before policy becomes “tight”.

Policies are loose because economies have needed help to recover from the GFC. If a central bank believes it’s time to tighten, it is fearing the inflation threat of leaving policy too loose for too long. Inflation only occurs in a growing economy. Interest rate rises are only equity killers if we are on the other side of the equation – economic growth is too rampant and needs slowing down lest it all ends in tears.

In other words (and the tapering response in December is testament to this), Wall Street may yet rise on confirmation a rate rise is nigh, as this implies a stronger US economy and thus increasing corporate earnings. It may fall during the preceding period of uncertainty as to whether one is nigh or not, but we’re arguably in that now.

It is possibly more likely Wall Street could correct if there is no rate rise being anticipated, or feared. For this would imply fears of the US economic recovery not being quite as robust as assumed are founded. Indeed, might it be possible global markets correct because global growth forecasts begin to roll over to lower levels of consensus?

This is proving a concern for JP Morgan’s global asset allocators. For each of the past three years, JP Morgan has forecast a rise in the global economic growth rate to 3% plus. Each year growth has only hit around 2.5%, but this has not stopped JPM having another go. As the analysts explain, the first two years provided excuses: European fiscal tightening (austerity), US fiscal tightening (sequester), and fading productivity in emerging market (call that a maturing Chinese economy). But outside of the Japanese sales tax hike, this year has provided no such excuse.

We might consider 2.9% of US March quarter weather-related contraction provides a bit of an excuse, but either way JP Morgan notes first half global growth of only 1.6% in 2014 suggests 3% is looking more of a pipedream than a forecast, and perhaps no more than 2% plus is realistic. Given current consensus is still for 3% growth, both in the US and globally, the risk is consensus will need to be pulled in.

And if so, perhaps equity markets might pull back.

Forecasting individual stock performance by first considering the macro picture of the global economy before working down to regions, sectors and finally the stock in question is known as “top down” analysis. Beginning with that stock’s earnings prospects before considering the general prospects of the sector, the region, and finally the global economy is called “bottom up” analysis. Typically top-down strategists hold bottom-up analysts in contempt and vice versa, and sometimes the bottom-uppers at one house can have a Buy rating on every stock in the sector, for example, while the top-downers at the same house have a Sell on the same sector.

This is not very helpful to confused clients, so BA-Merrill Lynch has told its own children they have to behave and play nice. The result is a team effort to align top and bottom analyses to then spit out a list of Best Picks, within Merrills’ assigned “super sectors” of consumer, basic materials, interest rate sensitive, resources/energy and transport/utilities. In Australia, a look at 141 qualifying stocks has produced a list of five “best picks”.

Merrills believes bottom-up analysis that nets out to a current 8% earnings growth forecast in FY15 for Australian stocks is too optimistic. Top-down analysis suggests low to mid single digits. The real concern relates to an overly enthusiastic margin growth assumption for industrial stocks (ex banks) that turns 5% sales growth into 13% earnings growth. If so, which stocks would Merrills hold?

Crown Resorts ((CWN)) is trading at an unwarranted discount to consumer peers despite a superior return on invested capital and resilient gaming revenue, Merrills notes. Origin Energy ((ORG)) should offer a free cash flow yield of 10.5% by FY18 when both APLNG trains are ramped up, has locked in its east coast wholesale gas price through to the early 2020s, and is no longer subject to a discount gas/electricity war now door knocking has ended.

Perpetual ((PPT)) is on track to cut 18% of costs through simplification and its Tru Markets acquisition offer 7-8% accretion, contributing to 20% earnings growth potential in FY15.

With the iron ore price showing signs of bottoming and Chinese steel mill inventories having declined substantially, Rio Tinto ((RIO)) looks cheap. Finally, Merrills suggests WorleyParsons ((WOR)) is one company for whom expectations of a rebound in margins are warranted, yet the stock trades at a 6% discount to global peers compared to a historical 20% premium.

Outside of best picks, the reluctant coalition has also looked into which stocks offer potential upside or downside risk in the upcoming result season.

Many Australian stocks now have significant exposure to the US, and the US quarterly earnings season is underway. Based on Merrills’ US analyst forecasts in relevant sectors the local team has extrapolated to decide Brambles ((BXB)), Amcor ((AMC)) and QBE Insurance ((QBE)) offer upside risk while Iluka Resources ((ILU)), Boral ((BLD)), Incitec Pivot ((IPL)) and Orica ((ORI)) offer downside risk.

Cash generation has become very important in today’s market, hence stocks becoming more cash generative offer upside surprise while those becoming less generative offer downside surprise, suggests Merrills. In the former camp are Brambles, Carsales.com ((CRZ)), Caltex ((CTX)) and Origin Energy while the latter camp includes Asciano ((AIO)), CSL ((CSL)), Downer EDI ((DOW)), Harvey Norman ((HVN)), Woolworths ((WOW)) and Monadelphous ((MND)).

FY15 forecasting is very dependent on outlook statements provided by managements at FY14 result releases (particularly if no formal guidance is provided). Consensus suggests accelerating sales/earnings growth for Ansell ((ANN)), Monadelphous, Woolworths and JB Hi-Fi ((JBH)) but each of these have suffered forecast trimming leading into the season, and Merrills warns further downgrades could be ahead.

Adelaide Brighton ((ABC)) and Iluka Resources report interim results this season and are more heavily reliant on second half (ie to December) earnings in 2014 than usual to meet full-year numbers, implying downside risk, while QBE is less reliant than usual this year, implying upside risk.

Finally, Merrills has found in the past that opportunities exist when changes in consensus earnings forecasts contradict share price moves. Ramsay Healthcare ((RHC)) and Bank of Queensland ((BOQ)) have both seen modest earnings upgrades but their share prices have fallen, while the share prices of Aristocrat Leisure ((ALL)), Cochlear ((COH)), Myer ((MYR)) and Qantas ((QAN)) have all risen when earnings forecasts have fallen, and that makes Merrills “wary”.
 

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