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Weekly Insights From The FNArena News Desk
Friday, 21 August 2009 (This email was sent out to paying members on Monday)
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Understanding The Rally
By Rudi Filapek-Vandyck, editor FNArena
It is a widely held misconception that equity markets standard perform much worse in September and October than they do throughout the other ten months of the year.
History shows September and October tend to generate most of the fallouts and crashes that can severely hold back share market performances. Simple reviews of historical data thus suggest a negative return is most likely, but strip out these unusual events and this negative bias disappears from our calculators.
Having said so, last year saw economic growth in China tumble and one of the oldest financial institutions on Wall Street go bankrupt in the period. The result was the S&P200 index fell from 5000 in the third week of September to below 3800 by late October.
However, the three years prior saw only one October (2005) generate a slightly negative share market performance against two positive Octobers and three positive Septembers. In 2007, in what was arguably the initial stage of the bear market that followed, equities rallied strongly throughout September-October, until they peaked by early November.
This year, the number of expert warnings is once again on the rise now that September is approaching on the calendar.
Apart from the suggested seasonal minefield, most warnings are based upon the fact that equities and commodities have run hard this year, thus making some sort of a correction but a logical consequence of the future. To properly assess the merits of these warnings, let's have a look at what lies underneath the recent rally first.
Personally, I don't put too much value into what happens at face value in equity markets. Similar to last year when sizeable falls failed to indicate anything about what lies ahead (the fact that equity markets had fallen 25%, or 35%, or 50% didn't prevent them from falling further), this time around I don't believe the fact that equities this year are up 40%, or 50%, or 60% from their lows tells us anything about what happens next. It's what lies underneath these gains that should hopefully provide us with better insights.
Looking into the details of the recent rally actually reveals a positive story. Economists and securities analysts have been revising their forecasts and expectations upwards. This has had a significant impact on implied stock market valuations. To put it simply: shares of BHP Billiton ((BHP)), to name but one example, are now cheaper trading at around $37 than when they were at $32.
This is because market expectations have surged higher and more rapidly than BHP shares have in the June-August rally.
What applies to BHP Billiton effectively applies to the share market in general. This now brings us to the odd situation that while share markets have put in some strong performances over the weeks past, they have on balance only become slightly more expensive, trading on a forecast 13 times average EPS for FY11. This was around 11 prior to this last rally.
If the first two weeks of the Australian reporting season are any indication, the news is likely to only get better from here onwards as analyst forecasts finally seem to have fallen low enough so now companies can surprise to the upside, triggering analyst upgrades, and so create further positive momentum underneath the share market. All things being equal, the Australian share market should be cheaper by the end of August than it is now, even if shares would trade sideways instead of pulling back.
This, however, does not automatically imply that the current rally will simply continue upwards and onwards into the new calendar year. On shorter term metrics, the Australian share market is now trading above 15 times FY10's average forecast EPS multiple for the top 200 Australian companies, and that number surges closer to 16 if we exclude the banks, which are -believe it or not- still trading at below market multiples.
Fifteen times next year's profits is about the historical average valuation for the Australian share market. The market multiple reached about 17x during the peak in 2007, so any suggestion of another bubble or "irrational exuberance" seems misplaced - especially if we take into account that rising expectations will automatically push the multiple lower by the end of August.
The problem is, however, this doesn't appear to be the case in the US where shares are believed to be trading at more than 18 times next year's average EPS, or well-above the historical standard of 17. Problem number two is less imminent but will present itself sooner or later: assuming the share market will, through dips and pullbacks, ultimately rise until it has priced in 15 times the forecast average EPS for FY11, what follows next?
Problem number one indicates that as long as the Australian share market continues to take its main lead from US markets, the next few months may turn out tricky. Any share market at lofty valuation levels is by default more susceptible to data-disappointments than otherwise.
Problem number two implies the Australian share market still has room to appreciate further. A loose, back-of-the-envelope calculation teaches us that 10-15% in extra potential seems about right. (We'll have to wait for the changes made in the weeks ahead before we can draw more concrete conclusions). This would take the ASX200 index back to around the 5000 level which seems to feature a lot in projections made by market commentators who like to look back. The Australian share market was trying to stabilise around the 5000 level last year before all hell broke loose because of the Lehman Bros collapse.
Equally, the 5000 level is often cited by technical chartists as well as this was the level that first provided support to the market last year and subsequently became technical resistance (as witnessed in September 2008 when the market failed to surge above 5000 again). In addition, 5000 represents a 50% retracement from the peak levels in 2007. This is a key target for chartists who take guidance from Fibonacci calculations.
>From a pure PE valuation point of view, 5000 makes a lot of sense. Though we have to keep in mind that FY11 is still some time off, and we have yet to assess what FY12 can possibly bring us. Also, investors have yet to find out whether the market will continue to accept a multiple of 15 if economic growth turns out lower than expected, as is currently assumed by many.
On a more personal level, the above analysis has provided me with a better insight into what has taken place in commodities markets thus far too. We don't have underlying PE numbers to put a valuation on present prices for crude oil, copper, iron ore and other base materials, but since most of these markets have rallied in close correlation with equity markets, it's probably safe to draw a similar conclusion as for Australian shares: investors have run ahead of short term fundamentals based upon belief that a new uptrend is in place for which actual fundamentals will likely fall in place on a two-year horizon.
As long as this belief remains in place all pull backs should remain benign - at least until FY11 has been fully priced in. The timing of this will largely determine what comes next. For now, however, it would seem this market still has plenty of breath left, even if it is well possible that on a shorter term timeframe some headwinds might present themself.
This story was originally written and published on 17 August 2009.


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Highlight Stocks
BHP - Similar to my argument last year that falling share prices doesn't necessarily make them cheaper, this year the same thematic is revealing itself, only in an opposite manner. As market forecasts are rising, higher share prices do not automatically mean these shares are becoming more expensive. The changes emanating from revised forecasts can be quite significant. A few weeks ago, BHP Billiton ((BHP)) shares were trading at more than 22 times FY10 forecast EPS and at around 17 times EPS for FY11. Today these numbers have changed to 17.2 and 12.2 respectively. Note: the implied FY11 multiple is "below market".