Share markets - where to from here?

With share markets up substantially from their March lows, the big questions now are whether the rally is sustainable and what sort of returns we can expect going forward. While there are some problems (high debt levels, terrorist threats, etc), our assessment is that further gains are likely over the next six to 12 months, but the pace of the gains will be slower than has been the case over the past six months.

The rally so far

It is now six months since global share markets turned higher from their pre-Iraq war lows. The relative underperformance of the New Zealand market during the recovery in large part reflects that it fell far less during the bear market (which began in March 2000).

Key indicators

In assessing the outlook for share markets over the next six to 12 months, we looked at five key variables: valuations (are shares cheap or expensive?); the earnings backdrop (are profit expectations improving?); liquidity conditions (is money cheap? is there cash sitting on the sidelines?); investor sentiment (are investors too bullish or bearish from a contrarian perspective?); and technical conditions (is recent market action suggesting further gains ahead?). Looking at each of these in turn:

• Valuations are reasonable - A comparison of earnings yields on stocks (using 12 month ahead earnings) with 10-year bond yields still favours stocks over bonds. In many markets, dividend yields (after imputation credits in New Zealand) remain at or near bond yields. Using a range of valuation approaches we judge the US to be mildly expensive and Europe, Asia, Australia and New Zealand to be mildly cheap. As such, while share markets are no longer as cheap as they were back in March, valuations are not yet at levels where they might cause problems.
• The cyclical/earnings backdrop is positive – recent company profit results were far better than expected and year-ahead profit expectations have been moving higher on the back of favourable earnings guidance and improving economic conditions. The just-ended June half profit-reporting season in New Zealand was the best since 1993.
• After several years of cost cutting, both by US and New Zealand companies, earnings are now highly leveraged to economic recovery.
• Liquidity conditions are very positive – monetary conditions are very easy everywhere and there is plenty of cash sitting on the sidelines. In the US the value of money market and savings deposits is equivalent to about 45% of the US share market's capitalisation, compared to just 20% three years ago. The threat to share markets from rising interest rates normally doesn't come until we are near the top of the economic cycle and inflation is threatening to become a problem.
  This seems a long way off at present. In fact, given excess capacity and related deflationary risks, central banks in the US, Europe, Japan and Asia are unlikely to raise rates until well into next year.
• Sentiment conditions are generally bullish which is a worrying sign from a contrarian perspective. Surveys of US investors and investment newsletter writers indicate that sentiment toward stocks is extremely buoyant, raising the risk of a near-term correction. However, while such indicators are 'flashing orange', a possible offset is coming from hedge funds which have been caught short US stocks this year. If they go long (ie. start buying) it could provide further upside to the US market.
• Finally, recent action in the US share market (which sets the direction for all others) is positive from a technical perspective. The downtrend from March 2000 has recently broken. Since October (when the US market bottomed) we have seen a pattern of rising lows and rising highs, indicative of an uptrend, while the breadth of the rebound has been positive, suggestive of further gains over the next six to 12 months.
• Overall, shares are no longer super-cheap like they were in March and it is fair to say that the 'easy gains' have been seen. Future gains will be much more in line with earnings growth. But with the global economy continuing to improve, earnings expectations improving and the liquidity backdrop very positive, further gains are likely.

So what are the risks?

As always there are risks worth monitoring.

Markets are arguably due for a correction from a technical perspective. Cyclical bull markets don't occur in a straight line and after a strong rebound over the past six months, a near term correction is possible before the recovery then resumes.

The terrorist threat remains alive and well, though over time share markets will become hardened to it and thus will respond less to actual threats or events unless they severely damage economic infrastructure.

There is also the question of what will drive US growth in 2004 once the stimulus from tax cuts and mortgage re-financing runs out. While this is clearly a risk, business investment is likely to take over the running from the consumer in driving growth through 2004, reflecting rising profits and stronger business confidence. Next year should also see a broadening in economic growth globally with other regions kicking in more strongly even though the US may decelerate slightly.

The US economy’s imbalances (such as the trade deficit blow-out, high debt levels, etc) also remain alive, though there is a danger in exaggerating them.

In assessing the risks though, it should be noted that the past three years have seen an unusually large combination of negative events for stocks (collapse of technology stocks, recessions, large scale corporate collapses, terrorist attacks, war, SARS, etc), which are hopefully unlikely to be repeated for a while.

Conclusion

Overall we see further upside for stocks over the next six to 12 months reflecting reasonable valuations and the classic 'sweet spot' combination of improving growth, low inflation and low interest rates. While a near term correction is possible, the favourable backdrop should help ensure it will be mild and that any seasonal weakness over the next month or so should be viewed as a buying opportunity.

It is worth noting though, that the easy double-digit gains in share markets have been had. Share price gains over the next six to 12 months are more likely to be in line with underlying profit growth and thus more modest.

This article was provided by AMP Henderson

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