Bull, Bear or Devil-May-Care

With the United States’ S&P 500 index up over 7% for October and up over 23% for the first ten months of this year, despite some poor recent economic numbers (consumer confidence and employment growth) partly caused by the government shutdown, it’s probably worthwhile focussing on a question we are getting from investors. How can this bull equity market continue with growth and company earnings so sluggish and valuations looking more and more stretched?

It’s definitely been a good year so far to invest in developed market shares as shown in the following chart.

Country	Index	Return YTD	Economic Conditions	Latest News / Issues
Australia	ASX200 (Accum.)	21%	Sluggish coming out of post-mining boom	Reserve Bank tries to talk dollar down.
US	S&P 500 (Price)	23%	Moderate growth in the face of fiscal contraction	Signs of recovery before debt ceiling dramas.
World	MSCI World in USD (Price)	19%	IMF downgrades world growth again in October (to 2.9% in 2013 and 3.6% in 2014)	Most developed nations continue with massive QE programs.
Japan	Nikkei 225 (Price)	38%	Abenomics gives an artificial short term boost	Will an increase in GST curtail growth? Will structural reform eventuate?
UK	FTSE 100 (Price)	14%	Recovering	Business confidence hits 10 year high.
Germany	DAX30 (Price)	19%	Moderate growth	1.4% Growth expected in 2014.
France	CAC 40 (Price)	18%	Sluggish, weak labour market	Protests over tax hikes as government tries to meet Euro targets.
Korea	KOSPI (Price)	2%	Fiscal and monetary stimulus to drive rebound	Slowing trend growth in Asia, regional susceptibility to US QE removal.
China	Shanghai Composite (Price)	-6%	Growth stabilising	Ongoing concerns about health of shadow banking sector. Transition to lower but better quality growth.
Aussie Bond Index	UBS Composite	1.6%	Rising bond yields have weighed on returns	10 year bonds at over 4.15% now fair value.

Source: Perennial, Iress

 
The bottom line is of course that markets are much more subtle than just responding to say forward estimate Price to Earnings (PE) valuation measures, rather it’s a combination of rational valuation outlook, future gazing, cash flows (Australia certainly gets influenced dramatically by overseas investors) and pure “animal spirits” that determine market movements. Certainly the US is key here from many perspectives as it does lead market sentiment. If you look at the US market major corrections over the last four decades they have been associated with a new “crisis” developing in global markets, big hikes in the oil price or the Fed raising rates. Looking forward investors are seeing the risk of these events occurring as low, particularly with QE tapering appearing to have been pushed out to next year. Apart from some sluggish fundamentals, the major negative for the US has been the back up in bond rates (US 10 year treasuries from 1.76% to 2.55% today) but equity investors have lately taken that in their stride with an almost obsessive focus on tapering.

The recent Nobel Prize winner Robert Shiller who came to Australia a few years ago to address some Perennial functions runs a long term series of longer term US PE numbers where he takes the current price and divides by the 10 year average past earnings, all adjusted for inflation (he called this CAPE, the Cyclically Adjusted Price Earnings ratio). While it was never intended to be a buy/sell signal in itself many are taking the current measure of around 25x as a sell signal compared to the longer term average of 16.5x. Interestingly, as recent as this week Shiller commented in an interview “the market is high, but it’s not alarming yet and could go much higher”.

So, what should we do in terms of our equity asset allocation? I guess it falls into how you view the current situation – let's look at four possible approaches.

Approach 1. “Valuation Rules”
At the end of the day, despite all of the government monetary stimulus with record low rates and massive QE programs, shares have risen without a corresponding rise in top line earnings (we’ve seen some effective cost cutting). Left field risk abounds and it’s time to take some profits.

Approach 2. “Global Growth Believers”
Global economic growth will eventually accelerate and the sharemarket is just doing its normal thing of factoring in future earnings growth. Remember when the “E” in PE rises, PEs can fall quite quickly. On that basis the bull market will continue.

Approach 3. “In Governments we Trust, but not the economy”
While we have governments holding rates low and buying assets in the US, Japan and the UK with China currently pro-growth, sharemarkets will not look back. Hold on for now but as soon as governments start to back off (eg the US starts to taper), watch out!

Approach 4 . “In Governments we Trust and also the economy longer term”
Similar to Approach 2, but for slightly different reasons. While valuations are a little stretched I have the short term “safety net” of massive government support for the markets and in the longer term growth will pick up. While there may be some concerns, say when the US starts to taper, people will soon realise that this signals the start of more robust growth which will support the world market.

At Perennial we are more along the lines of Approach 4, where markets appear to be supported by government actions and the longer term looks positive, however the transition from Government supported growth to underlying organic growth may prove to be a bumpy ride for equity investors.

Indices:

The Australian All Ordinaries Index has moved up decreasing by -0.2% since closing last Friday to 03:55 pm today.

The rest of the world as measured by the MSCI index decreased -0.3% in A$ from closing last Friday to end of trade Thursday.

Have a great weekend,

The team at IPS