Cycling valuation

- compiled from information from GSJBWere Asset Management


The rally in the sharemarkets since March has been driven by a turnaround in the economy rather than a turnaround in profits according to GSJBWere analysts. “The rally was born out of fear that credit ructions would cause a lengthy and permanent impairment in the global economy.” Previously, markets had sunk to levels which were the lowest in 30 years.

Once the measures taken by governments to bail out banks and provide credit were perceived as being successful markets rallied strongly. However predicting the timing and strength of the rally was always going to de difficult. As more evidence of a global recovery grows, the drivers for the stock market are likely to change.

Since March 2009 the rally has been a valuation rally rather than a rally driven by earnings - markets have risen despite a deteriorating earnings outlook. According to GSJBWere analysts this is both appropriate and normal. Market participants have taken comfort in a turnaround in production, improving business and consumer indicators and have bought ahead of the ensuing recovery. As they say, it is clear that this is not a situation that can continue forever – the valuation rubber-band has limits.    
     
Past market cycles are useful in understanding the pervasiveness of rallies driven by valuation. GSJBWere analysed the performance of Australian equity markets with respect to a measure of global production intentions - new orders data from a survey conducted by the Institute of Supply Manufacturers (ISM). They segmented the cycle into four phases: slowing growth, decline, recovery and accelerating growth, and looked at the drivers of returns, earnings (measured by Earnings per Share; ‘EPS’) or valuation (measured by Price/Earnings ratio; ‘P/E’).

They noted that “during the initial phase of a slowing economy, markets remain supported by growth remaining positive, yet start to discount the strength of corporate earnings as questions around their sustainability increase. Valuation declines mitigate the strength of corporate earnings and suppress market returns. The decline phase is the most negative as earnings ‘flat-line’ while valuation remains a headwind for markets. Typically, markets produce negative returns during this phase with large retracements delivered during recessionary (negative growth) episodes. The recovery phase is the most powerful. Despite the fact that earnings remain static, markets rally on the expectations of future growth, driven higher by valuation expansion. During the growth phase both earnings and valuation contribute to the markets rise.”

Where are we in the cycle?

GSJBWere analysts noted that “the August reading of the ISM index signalled that the outlook has turned from recovery to growth. This is the time when the driver of future market returns switches back to the earnings outlook. During what we label the ‘macro to micro’ transition, returns remain positive but moderate from the exceptional returns that accompany a turning point in the cycle.”

Analysts can identify the period before and after a bottoming in market earnings by looking at the price to earnings (P/E) valuation moves of the market over past recessionary periods. It has been found that leading into this period, valuations typically expand, with the only exception in Australia being the 1973 period when inflation concerns suppressed this expansion. After the bottoming of earnings, P/Es usually contract as the market becomes focused on the earnings outlook and the extent of recovery. With the Australian market now trading at above average P/E ratios, and the ISM index moving through the growth/decline level GSJBWere believe that this phase has been reached.

In the latest reporting period company outlooks have recognised they are currently passing through a low point in earnings. Nevertheless, earnings trends remain encouraging. Firstly, analysts have started to revise earnings upward. Once earnings are revised upward, they continue to move higher for an extended period of over 12 months. Just as analysts are typically too optimistic at the top of the cycle, they are usually too pessimistic at the bottom. Secondly, a reality check of analysts’ forecasts of bottom-up earnings shows that they remain conservative.

GSJBWere analysts studied the history of Australian corporate earnings over the past 25 years. They found a trendline that signals a normal level of earnings and a macro-economic model which is driven by current credit growth and commodity prices fit well with the earnings experience. Analyst estimates for 2010 earnings remain 15% below the historical trend as well as macro-economic estimates, signalling both caution on behalf of analysts, and upside potential in forecasts.

“With the cycling of valuation as a driver for equity market returns more emphasis should be placed on detailed industry and company analysis. Once central banks gain comfort that economies are on sustainable footings, macro-economic influences currently supporting markets will wane and attention will turn to the corporate profitability and execution of individual strategies. We would expect a similar phenomenon in asset markets: the broad based re-risking trade will moderate and returns will be dictated by the underlying fundamentals of each asset class, ” they conclude.