Do we need to prepare for a lower tide?

Although the Australian sharemarket has risen strongly in early 2007, price growth has exceeded expected earnings growth. Matthew Sherwood, Manager, Investment Markets Research at Perpetual Investments discusses why downside risks for sharemarkets have increased and how to navigate through what could be a more challenging environment.

Although we usually overlook it, great people in history made simple mistakes. For example, Captain James Cook ran his ship, the Endeavour, aground on the Great Barrier Reef in 1770. Although this master seaman had never sailed around the world before he undertook this famous voyage, it is amazing that he could not ascertain that the sea levels in this waterway were too shallow for his ship to pass through. The ship was seriously damaged and after a four week patch-up job, it progressively limped to Batavia for expensive permanent repairs. This indicates that experts can overlook the obvious and pay a large price. Unfortunately, financial markets are no different.

Mapping the investment landscape

Developments in the global and Australian economies have supported the Australian sharemarket and enabled it to outperform its historic average return (12.5% per annum – see Chart 1)) in each of the past four calendar years. This is only the second time since 1934 that the Australian sharemarket has outperformed its historic average in four consecutive years and primarily reflects strong earnings growth in our two largest sectors; financials and materials.

Chart 1: Australian sharemarket returns have been strong since 2002

Annual Australian Sharemarket Returns (%)

However, the recent rise in the Australian sharemarket has taken on a more speculative nature as heightened corporate activity by cashed up private equity funds has prompted investors to focus on takeover targets rather than earnings. The frenzy of corporate activity has been concentrated in the industrial sector and primarily reflects sustained low global interest rates and the de-leveraging of Australian corporate balance sheets, which combined with high cash reserves, have made

these stocks easier targets.

Pinpointing our location

Similar to the economic cycle, the sharemarket tends to go through four distinct stages;

1. Recovery from market downturn as investor optimism improves (such as in 1983, 1992 and 2003)

2. Consolidation of price gains based on sustainable earnings outlook (1984-86, 1993-98, 2004-06)

3. Excessive optimism as price growth outweighs earnings growth (1987, 1999-00, and 2007)

4. Realignment of earnings and price growth (1987 and 2001-02).

The duration and rates of return during each stage varies from cycle to cycle and it is not always apparent when the market has moved from one stage to the next.

So what stage are we currently at? Given the Australian sharemarket’s sustained recovery since early 2003 and the fact that the market is now at a record high, it is clear that we are at either stage two or three. Our location within these two stages is best identified by examining the earnings outlook and market valuations relative to history.

a. The Australian sharemarket’s value seems okay, but …

The forward looking P/E ratio of the Australian sharemarket has risen over the last four years to 15.5, which is marginally above its post-1994 average of 14.5 (see Chart 2). This suggests that on a broad market basis the Australian sharemarket is near fair-value. However, the market’s P/E ratio is being held down by the low P/E ratios of BHP Billiton and Rio Tinto (which are experiencing top of the cycle earnings growth) and the four major banks (which are benefiting from strong credit growth). These six companies account for 31% of the S&P 200 Index and have a combined P/E ratio of 12.4, which is in line with their post-1994 average and well below the market average.

Chart 2: The Australian sharemarket’s valuation is not as attractive as it appears

Australian Sharemarket Valuations: PE Ratio (X)

The remaining stocks in the S&P/ASX 200 Index are trading on an average P/E ratio of 17.4, which is well above their post-1994 average of 15.3. The last time this group’s valuation was at this level was during the tech boom, during which News Corporation, for example, represented 20% of the Index and traded on a P/E ratio of around 50. These high valuations declined in 2002 in response to a deteriorating economic backdrop.

b. The earnings outlook is moderating

Although 2006 represented the Australian sharemarket’s fastest year of earnings growth in more than a decade, this growth rate has moderated in 2007. Within the market, there is only a modest difference between resource stocks (expected to grow their earnings per share at around 15%), banking stocks (12%) and other industrials (11%). This indicates that the 2007 earnings outlook for the Australian sharemarket remains positive, but well below the levels experienced in 2004 (18%), 2005 (21%) and 2006 (27%).

Has the tide gone out?

A rise in Australian sharemarket valuations during a period of moderating earnings growth indicates that we have entered stage three. This stage typically experiences the highest risk, as excessive valuations are not sustained and stage four is the only stage which potentially experiences negative returns. This indicates that downside risks to the Australian sharemarket have increased as earnings growth has slowed from its high water-mark of 2006. However, slowing earnings growth, rising valuations and higher interest rates do not necessarily signal that the market is poised for a major correction in the short-term.

Interestingly, rising sharemarket valuations have an inverse relationship with long-term returns, which suggests that returns in the next five years could moderate from their recent pace (see Chart 3). If the historic relationship holds, current market valuations (around 15.5 times earnings) should, on average, translate to an average five-year return of around 7% per annum. When this price growth is combined with a 4% dividend yield, investors would, on average, expect to receive low double digit returns, which are close to the historic average, but well below the levels experienced in recent years.

Chart 3: Higher valuations traditionally precede a moderation in sharemarket returns

The Australian Sharemarket: PE ratio and 5-year returns since 1975 (X,%)

Should we cast the life rafts in response to the lower tide?

As we witnessed in the late 1990s, sharemarkets can remain at stage three for several years. Although downside risks appear to have increased, investors need to examine the defensive qualities of their portfolio, rather than selling their Australian share holdings and investing the funds in bonds or cash. The key question for investors is how to gain access to stocks that are likely to do well in a tougher investment climate, without bearing unnecessary risk. During previous periods of heightened risk, stocks with high earnings certainty, good dividend yields and attractive valuations have provided investors with positive returns in a risk-efficient manner.

The tide is lower, but the market should remain afloat

With downside risks to the Australian sharemarket having increased, returns are likely to moderate to a more sustainable level in the next few years. In this environment, stocks with high earnings certainty and attractive valuations should perform well, whereas exposure to overvalued growth companies is unlikely to reward investors. Just as Captain Cook should have realised in 1770, there is a time for daring and a time for caution and a wise person knows which is called for.

Matthew Sherwood

Manager, Investment Markets Research

Perpetual Investments