On Friday I returned from four weeks travelling through Zimbabwe and neighbouring countries. I now have first observer experience in how an economy marred by uncontrollable hyper-inflation is changing into one that is facing deflation. This trip has provided me with lots of energy, new ideas and insights. I will return to this unique experience in due course.
What has come as a surprise, however, is that investors have used the quiet period of the year, in between Christmas and the New Year and into the first trading days of January, to push up share markets and commodities, and to push them up significantly.
This, as expected, has re-ignited overall market optimism. Already in my first telephone conversations this week I picked up statements such as "it's going to take a lot to keep share markets down this year" and "it's looking mighty good for the year". Odd. My initial response is always: does it still look good AFTER such a big run? This as opposed to market optimism in general, which seems to grow as asset prices rise.
Let's have a quick look backwards, to put things into the right perspective. When I left Australia in mid-December the Australian share market (ASX200) was ostensibly going nowhere, oscillating around the 4600 level. Yet, here we are in the second week of January and if it wasn't for some disappointing corporate results in the US (Alcoa, Chevron, Electronic Arts) and a surprising policy move in China we'd probably be staring at index levels near 5000 by now.
Now that is by anyone's account a big move upwards.
BHP Billiton ((BHP)) shares were at $40-something in December. They seemed on their way to cross the $45-mark earlier this week. Similarly, the $55 level seemed a bridge too far for CommBank ((CBA)) shares in 2009. This week the shares had no trouble in crossing that line. And that's not even mentioning stocks such as WorleyParsons ((WOR)) that went from $26 to past $30 in six weeks (more about that later).
It is a similar picture among commodities. Back in December, copper futures were struggling to remain above US$7000/t, yet they stormed to US$7700/t. Nickel futures have gone from US$17,000/t to above US$19,000/t and now back to $17,500/t. Crude oil was holding firm in between US$70-75 per barrel last year, yet WTI futures almost touched the US$85/bbl price level this week.
I have no problem with either of these prices. The global economic recovery is seemingly continuing and it is thus no wonder this has translated into higher prices for levered risk assets. The problem I have, however, is that we're still in the second week of January -in other words: we have yet a whole twelve months in front of us- and a lot of the future upside appears already priced in.
Sure, there are quite a few oil bulls in the market that see prices move beyond US$100/bbl sooner rather than later. But isn't that supposed to be more of a 2011 story instead of one that comes to fruition in the first two weeks of 2010? (Not to mention the size of global inventories).
Over the past two years I have developed one simple rule: if price charts start looking like a near perfect line into the sky, it's probably not fundamentals that are driving the price rise, but money flows instead. Now, take a look at the S&P500 index between mid-December and earlier this week. One can hardly draw the line any straighter. Or take a look at crude oil prices, or at copper over the same period.
I think what has happened is too many investors have leapt into the same direction once again. This time it happened at a time of low volumes. The combination of the two leads to straight lines on price charts. And straight lines on price charts tell us things are going a bit too fast, too hard.
It's always difficult to predict exactly when and how overheated markets will correct, but it's probably a fair assumption that Tuesday's reversal for equities and commodities has longer to go still. The last time something similar happened was between October and early December for gold. Gold prices are still struggling with the fall-out of that experience.
I think it's going to take a while before we see gold printing a new all-time high. Luckily, for the many gold bugs in the market, the price of gold didn't go completely gaga last year, like crude oil did in 2008 or uranium in 2007 – or even like gold did in 1980. If it had I would be very confident in dismissing all projections of gold reaching new highs later this year.
Similarly, when it comes to equities, I would agree at this early stage in the new calendar year that investors have once again moved a bit too fast in pushing up prices for the above mentioned assets. But this is not a repeat of 2007 (at least: not yet) and thus the outlook for 2010 hasn't yet been spoiled.
I am well aware that some commentators elsewhere continue to argue that shares are too expensively priced after nearly ten months of gains. Some are using backward looking Price-Earnings (PE) multiples, others use this year's forecast PE ratio. I haven't changed my view that for the most accurate view on present valuations in the Australian share market, investors should take guidance from FY11 projections, and largely ignore the other two.
I would personally never use backward looking multiples as they ignore what lies ahead of us (and I simply cannot understand why in the present modern age people continue using them). As far as this year's PE ratios are concerned: because of the economic recovery in progress, and the natural lag to company profits, I advocated last year that FY11 valuations are the most accurate measure for longer term investors. I have little doubt that in twelve months from now this view will be proven correct.
As such, the news for investors in the share market remains positive. On Deutsche Bank calculations the average PE ratio for the Australian share market is still below 13 (FY11). Considering the long term mean of 14.5 this means there's still plenty of value to be found in the market today, even without counting on further upgrades to corporate profit expectations.
If we take Deutsche Bank's calculation as our starting point, and we assume a return to the long term mean by year end, this would imply the ASX200 index should reach 5500 this year; again, no further increases to profit expectations are included.
However, Deutsche Bank's coverage is rather limited, as the wholesale stockbroker doesn't bother to research smaller caps. If we take all consensus forecasts for all ASX200 companies the average PE ratio for FY11 blows out to 24-something. This is because there are quite a number stocks, such as Eastern Star Gas ((ESG)), that are trading on ridiculously high profit multiples (these stocks obviously trade on different metrics – in this case: take-over appeal).
If we take out these aberrations, the average PE multiple for FY11 falls to 14.5 – exactly the same number as the long term average.
What this means, in my view, is that stock selection will become increasingly important this year. Value-seekers might want to use FNArena's R-Factor to locate value in today's market.
The R-Factor was originally designed to look at the share market on a relative, two-year horizon. To increase its usefulness FNArena has now added a new tab which focuses on one thing only: what's the stock's PE ratio for FY11. The lower the better? Investors should always keep in mind that stocks with an exceptionally low valuation always come with exceptionally high levels of risk – that's simply how the market works.
But if we take 14.5 as our starting point, then ANZ Banking Group ((ANZ)) with a PER of 10.8 and a prospective dividend yield of 6.1% simply looks cheap. And the same can be said of Singapore Telecom ((SGT)) trading on a PER of 10.5 and an estimated dividend yield of 5.6%. Bradken ((BKN)) is on 10.3 and 4.9% respectively. Even BHP Billiton ((BHP)) on a PER of 12.5 and a dividend yield of 2.7% can still be regarded as being on the relative cheap side of the market. Upcoming iron ore negotiations can potentially provide the company's future bottom line with a big boost, though a stronger Aussie dollar will have some serious impact too.
As far as the discussion defensives versus cyclicals is concerned: Woolworths ((WOW)) shares are trading on a FY11 multiple of 15.6 (4.5% yield). CSL ((CSL)) is on 15.1 (2.5%) and Cochlear is on 21.9 (3.4%). None of these companies' growth trajectories over the next two years is likely to come even close to the companies I mentioned in the previous paragraph (with the exception of SingTel).
Finally, to start the new year on an innovative note: I hereby formally announce that I will no longer refer to China and India as "emerging economies". I will use the upgraded label "emerged economies" instead. I think others should do the same. For obvious reasons.
One more thing: it is my personal view that energy and materials companies will likely deliver most of the profit disappointments during the upcoming results season. Already, Alcoa and Chevron have backed up this view. Locally, Energy Resources of Australia ((ERA)) and WorleyParsons ((WOR)) have been quick in adding some local disappointments of their own.
Let me see: one uranium producer and a service provider to miners and the energy sector… I think I'll stick to my view.
With these thoughts I leave you all this week,
Till next week!
Your editor,
Rudi Filapek-Vandyck
(still struggling with jet lag and as always firmly supported by the Ab Fab team at FNArena)