Yesterday’s spectacular bounce in the Australian sharemarket, after the deepest losses on Wall Street in two years, is demonstration of the opportunities to be had trading in volatile markets as prices whipsaw violently about.
Trading is not for the faint-hearted, though, or those who can’t afford to lose. The volatility of the market, over time, exceeds the capacity of most investors to handle it. But it’s worth keeping an eye to fundamentals, even when sentiment has taken over.
It’s undeniable that violent sharemarket falls are inevitably followed by sharp market rallies.
Since Friday’s low point, the S&P 500 had fallen 13 per cent in 10 days. Thanks to Monday night’s bloodbath, it was down almost 20 per cent in a couple of weeks.
Looking at the four other 10-day falls of more than 9.5 per cent since World War II – 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.
The ASX 200 is trading on a forward-earnings multiple of only about 10.3x – an ample 29 per cent discount to its 10-year average.
It’s cheap. But are these sorts of broker assumptions to be relied on?
A good deal of stockbrokers’ research pushes 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 timeframe.
Looking at share values over the past decade alone, and averaging them, which is how the brokers often make their historical judgments about market value, misrepresents the truer, longer-term picture.
Between 1990 and today the average household debt has doubled. It was during the past 20 years that leverage in the system really took off.
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 in shares. It pushed share prices and valuations to 20x forward earnings. It drove up the averages.
A 10-year view then of market valuation is deceptive. Yet these are the sorts of timeframes that are most commonly used to justify valuations. And the world is now deleveraging, so forward-earnings estimates should be contracting.
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.
Still, stocks look cheap here. Corporate balance sheets were replenished during the financial crisis, 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 8 per cent. It’s not very often we get the chance to buy a big-four bank stock yielding 8 per cent.
Corporations aren’t in crisis. It is governments in crisis now.
So, if these apparently attractive share valuations aren’t indicating the sharemarket 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.
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 when things are bombed out like yesterday morning, 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.
The risk, though, remains for a lengthy bear market, not a rapid rebound, as the world is in a long and painful process of deleveraging.