Is this as good as it gets?
What began as a legitimate search for higher returns following a collapse in prices in 2002 has left global sharemarkets teetering on the point of expensive. While fundamental analysis still points to being marginally overweight equities, it’s becoming more of an each way bet.
Tuesday, April 13th 2004, 9:57PM
From March 2003 to March 2004 it’s really been a one way street for equities. To give you a better idea, over that period the S&P500 has rallied 36%, the Nasdaq 52%, Germany’s Dax 58% and Korea’s Kospi 54% (in local currency terms).
There were certainly good reasons for this enthusiasm for equities, beyond low interest rates and robust economic growth. Profits, especially in America, have been extraordinarily strong. Share prices have also been supported by greater certainty about those profits, as well as healthier balance sheets. But do current prices now reflect the turnaround in global growth and profits? In an effort to answer this question I’ve considered the current market environment with respect to the economic cycle and valuations, as well as the level of risk being taken on by equity investors.
The cycle environment for equities remains moderately bullish. The US economy is growing at above trend pace, and is expected to register growth in excess of 4% for 2004. Supporting this expansion is a combination of low interest rates and unusually high tax refunds. And the recovery has now broadened beyond the consumer to the industrial sector. The rebound in manufacturing is reflected by the latest ISM (Institute for Supply Management) which shows that activity in the industrial sector remains as strong as it has been in twenty years.
The numbers out of Asia are also positive. China is still in the early stages of a new expansion cycle, and should continue to benefit from record foreign investment and growing consumer demand. Interestingly, China is in the midst of a consumer boom resulting from huge growth in the number of people now earning an income.
The economic outlook is equally as upbeat for countries such as Japan, Thailand and Taiwan where exports are up and consumer spending is buoyant. For Europe, the signs, while not as positive, are still heartening. Despite a marginal decline in February, the PMIs (which measure the level of activity in the manufacturing sector) have plateaud at levels consistent with modest economic growth. In addition, retail sales have bounced back in Germany and France and this all points to economic growth in the region of around 2.0% in 2004.
So it could be argued that the global economic backdrop remains supportive of equities. But the point to note is that the acceleration in growth is behind us, highlighted by the fact that the majority of GDP forecasts for 2005 are below that of 2004 and late 2003 (when economic growth peaked).
Looking at valuations, the signals are mixed. Relative to bonds, equities still offer significant value. In early 2003 there was a two standard deviation gap between the earnings yield of the US equity market and the earnings yield offered by US 10 year bonds. This gap has retreated to less than one standard deviation, which equates to International equities being around 20% undervalued. Similar analysis on the Australian market suggests local equities are around 13% undervalued.
But in an absolute sense, equities are beginning to look expensive. The P/E of the S&P500 is currently 20 times 2003 earnings, which is above the 20-year average of 15 times. Interestingly, when the US sharemarket has traded with a P/E in excess of 20 times, the subsequent 12-month return has been negative. The Australian market is not quite as expensive, trading on a P/E of 16 times, which is almost identical to its long-term average. So while P/E’s aren’t what you would call expensive, they are approaching the top end of the historical valuation range.
This means that the focus will now turn to the quality of company earnings and the likelihood of companies meeting consensus forecasts (or beating them). US earnings have surprised on the upside for the past 18 months. This has also been the case in Europe and Japan. However, as we pass through each quarter we are seeing significant upgrades to the following quarters’ numbers. And were getting to the point now were the forecasters are becoming quite demanding.
To give you a better idea, in Japan, consensus forecasts predict earnings growth for 2004 of 58%. While these numbers don’t seem impossible to achieve, if you take into account the fact that earnings were up 39% in 2003, you can see that the bar has been raised. Consequently, you could say that consensus earnings forecasts are going to become quite a bit more difficult to achieve.
In terms of taking on risk, equity investors are undoubtedly bullish. Even at the start of this year, just about every indicator of risk appetite suggested that investors have pulled out their chequebooks and have not been afraid to add a few extra zeros. In fact, flows into equity mutual funds in America in January reached a size exceeded only in the first two months of 2000.
This appetite for risk has resulted in a buoyant start to the year for initial public offerings after a subdued 2003. The extent of optimism is reflected by the fact that a recent IPO in China was 16,000 times oversubscribed. And the outlook for interest rates could fuel this speculation further. To no one's surprise, America's Federal Reserve left short-term interest rates at a 46-year low of 1% in March, again with heavy hints that they would stay there a while.
Perhaps for longer than most pundits had thought. Most in the market believe that rates in the US will not be raised until next year. Extraordinarily low interest rates pose a big problem for investors. The central bank's stance has encouraged punters to take risks on an unprecedented scale, unleashing an abundance of money into risky assets. It could be argued that this flood of speculative money is creating the beginnings of a bubble in some markets, including the Shanghai A-Share Stock Price Index in China, which is trading on a P/E of 42 times. So in terms of equity markets, you could say that while valuations are not yet stretched (and nowhere near the valuations we saw in 2000), some froth is beginning to appear, making investing in equities an increasingly risky proposition.
Moreover, let’s not forget that bonds have become cheaper over the past year. Yields on longer dated US bonds have risen by close to 70 basis points over the past 12 months, while Australian 10-year bond yields have risen by 80 basis points. So it’s not just a case of equities becoming more expensive.
So is this as good as it gets for equities? In the short term I would say yes, as I anticipate that investors are a little ahead of themselves, both in terms of taking on too much risk and overestimating earnings for the second half of the year.
This may translate into a further 10% fall in the US market over the short term. But I do expect the market to pick up again later in the year as it becomes increasingly apparent that the Fed will err on the side of caution when it comes to raising interest rates, and as we see more signs of a sustainable global economic recovery. Also supporting equities is the fact that there are few alternatives in terms of other assets classes at present. Cash rates remain near 40 year lows, property prices look expensive and bond yields are not exactly cheap yet when compared with equity prices or the dividend yields on offer.
Brigette Leckie is the head of investment market research at Perpetual Investments| « Expect the unexpected! | Inflation starts to stir » |
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