A bull story

by | Aug 9, 2011 | Business

Update Today is the best buying opportunity in the share market in two years. We know that because shares are well and truly at their lowest point since mid-2009 and more than 20 per cent off their highs of April this year.

While everyone else is selling, and the market is starting to look very cheap on the basis of forward earnings, it’s worth examining the “buy case”.

Forget about bears and bulls. It’s hyena time! (Reader comment)

Firstly, it’s undeniable that violent share market falls are inevitably followed by sharp market rallies.

Since Friday’s low point, the S&P 500 had fallen 13 per cent in ten days. Thanks to last night’s bloodbath, it’s now down almost 20 per cent.

Looking at the four other ten-day falls of more than 9.5 per cent since World War Two – 15.2 per cent in March 2009, 13.1 per cent in August 1998, 9.8 per cent in October 1987 and 9.7 per cent in November 1974 – six months later the market had rallied 58 per cent, 28 per cent, 24 per cent and 31 per cent respectively.

This compelling little bull angle was in a Goldman Sachs report, followed by the observation that even before yesterday’s nasty three per cent rout on the local exchange, the ASX 200 was trading on a forward earnings multiple of just 10.3 times – an ample 29 per cent discount to its ten-year average.

The broker mentions Metcash, Woolies, JB Hi-Fi, Harvey Norman and IAG for trading below their 2009 financial meltdown multiples.

That’s cheap, historically. All up: a market priced 30 per cent below average valuations on a sub-10x PER equates to a screaming, wailing “buy” one would have thought.

Buying case

But are these sorts of broker assumptions to be relied on?

We are not singling out the Giant Vampire Squid, as Goldman has been dubbed, for special consideration here – its research just happens to be at hand. All stockbrokers push the buy case, almost all the time. Indeed, over time, equities rise more than they fall which makes being a “permabull”, over time, a better option than a “permabear”. Time is precisely the issue though, or in this case the time frame.

Looking at share values over the past decade alone, and averaging them, is about as true to the real story as cropping out the spouse from the old wedding photo.

Between 1990 and today the average household debt has doubled. There is twice the leverage in the system. Margin loans, geared share portfolios, hedge funds geared 6-10 times by their prime brokers, equity redraws, double mortgages, structured finance and so on. This explosion in leverage fuelled the boom. It helped to price equities on 20x their forward earnings. It drove up the averages.

A ten-year view then of market valuation is deceptive. The bulk of these sorts of broker earnings valuations are done over a short time frame.

Moreover, earnings estimates across all the broking houses are probably still too high anyway. Roughly, analysts are forecasting a 15 per cent rise in earnings per share for Australian equities in 2012. This will have to come down. For one, thunderous earnings shocks are probably heading our way from the ructions in the US and Europe. And two, things have slowed down over the past couple of months.

Growth hopes

Only recently did the Reserve Bank revise its estimates for growth to average 2 per cent in 2011, that’s well down from its previous forecast of 3.25 per cent on May 6. The good news is the RBA tips GDP to accelerate to 4.5 per cent in 2012, above its prior estimate for a 4.25 per cent expansion. But that’s further out, and it looks a little more optimistic every day this global market turbulence persists.

While growth is slowing down then, inflation is speeding up in Australia. Consumer prices are expected to rise 3.5 per cent in 2011 – that’s up from the previous estimate of 3.25 per cent.

Still, stocks look cheap here. Corporate balance sheets were replenished during the GFC, nicely restocked with capital if you like, and company balance sheets are mostly in fine shape. The low share prices are matched by the high yields with bank stocks now yielding close to eight per cent. It’s not very often we get the chance to buy a Big Four bank stock yielding 8 per cent.

Same deal in the US, where second quarter earnings season is in full swing and the results have been fairly good on the whole, although the banks are talking a special hammering of late. More broadly though, debt levels are low, valuations cheap and some $US2.5 trillion in cash is swilling around on balance sheets.

Corporations aren’t in crisis. It is governments in crisis now. So, if these apparently attractive share valuations aren’t indicating the share market is a bargain, what are they saying? That earnings forecasts are too high, that the “E” in PE is inflated, that economic conditions are soon likely to deteriorate further.

Earnings risk

This is why the market looks cheap – there is a rising risk the touted earnings won’t come through.

The risk of further volatility is high. Nonetheless, for those intrepid enough to wade in and buy today when others are sidelined or selling, at least they are buying in the knowledge that they enjoyed far better prices than everyone else did this year – more than 20 per cent better.

That well-worn aphorism, “Don’t catch a falling knife” – or its precursor, “don’t stand in front of a runaway train” – is sound advice for playing about in bear markets. Over time, the volatility of the share market surpasses the capacity of most investors to trade it. In other words, if you are going to punt the stock market, only do it with money you can afford to lose.

DISCLAIMER: this writer does not have a licence to give financial advice and is sticking to the same view: that is, that the world is in a long process of deleveraging. Though there will be many trading opportunities – the market never proceeds in a straight line – it will take some time for this bear market to play out.


Michael West

Michael West

Michael West established michaelwest.com.au to focus on journalism of high public interest, particularly the rising power of corporations over democracy. Formerly a journalist and editor at Fairfax newspapers and a columnist at News Corp, West was appointed Adjunct Associate Professor at the University of Sydney’s School of Social and Political Sciences. You can follow Michael on Twitter @MichaelWestBiz.

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