Stronger recovery for market ahead

After a period of solid outperformance in 2007, the S&P /ASX 200 has underperformed other major stockmarkets this year, down about 9% so far in 2008 and 17% from its November peak. This is out of synch with the strong GDP growth Australia is experiencing so we can see some important signals from this poor market performance:

There are two reasons for this underperformance: 

• Weight of Money: The “hot money” from overseas has departed in anticipation of an RBA led slowdown in the Australian economy with growth expected to slow from almost 4% to 2.5% next year. The “hot money” is run by fund managers who are profit takers and who move in and out of markets quickly;
• Over reactive Equity Risk Premium: The global impact of the credit crunch has caused an over reaction from many investors. Australian banks, in particular, have been savaged, trading on price earnings ratios of 11 times at their lowest point in the last few weeks. The equity risk premium implied in the CBA share price for example, which dropped by nearly 20% over the last few months, implies that CBA’s earnings must fall by the same level – whereas in fact CBA’s earnings for the last half year have risen by 8%!

The chart below shows the divergence between resource and financial stocks this year

 

The confluence of these trends has seen analysts revise down their earnings forecasts for many leading Australian companies for FY2009.
 
And this year’s so-called “confession” season has seen more than 100 companies announce downgrades in their earnings guidance since the start of 2008. While some companies will under perform there are some clear signs for growth in quality stocks: take a look at the chart below which shows how Australian GDP growth is strongly outperforming the US: 

Source: ABS, Macquarie Research  

The market, of course, looks 12 to 18 months ahead and on this score the outlook for the Australian economy and corporate earnings appears stronger for three reasons:

• Australia’s terms of trade are likely to remain robust, underpinned by high commodity prices which support resource company earnings
• The RBA is likely to start lowering interest rates in early 2009 as inflation begins to retreat back into the target band of 2% to 3%
• Economic growth in the US should improve as the effects of multiple interest rate cuts and tax refunds kick in. 

Alpha’s view is that growth may in fact surprise on the upside next year. Look at these key indicators of corporate economic health:

• Corporate profits as a percentage of GDP are at their highest levels since 1988
  
  Source ANZ Economics
• Corporate debt levels are down to lowest levels since 1988: 
  
  Source ANZ Economics 

That is not to say there will not be pain: many consumers are under growing pressure from rising interest rates and higher fuel bills and rents.

And sectors of the economy, especially companies that rely on discretionary consumer spending, could find the going even tougher next year.

Of course, it all comes back to stockmarket valuations.

The market, now on an average PE ratio of just under 14 times historic earnings, is just under its long-term average.

Looking at the wider market, it is not wildly cheap, nor is it expensive. But there are plenty of stocks that have been over sold and still have great fundamentals. Watch these stocks recover rapidly as good economic news re-emerges.