The following note updates my previous technical and fundamental analysis of the S&P/ASX 200 market index both here and here. My previous assessment that the “market seems likely to struggle for a while longer” has been borne out, and overall with regard to the index not much has changed since the previous update on September 30. Sadly, the outlook has not changed much as yet, with valuations still far from obviously cheap territory and corporate earnings still under downward pressure. This report also includes a more detailed sector breakdown of performance.
As can be seen in the chart below, market prices continue to languish below the market’s previous uptrend line that had been in place since mid-2012. After a brief attempt to rally though October – with the index reaching a closing level of 5351.6 on October 23 – price performance has since broken down again with the 5000 level tested in mid-November and again this week. A break below recent support around 5000 would open the risk of a bigger correction to around 4655 points – which was the significant low during the mid-2013 market pull back.
Fundamental Outlook – valuations
As seen in the chart below, in outright terms the market still appears expensive, with the forward-earnings yield at around 6.6%, compared with an average since 2003 of 7.4% (which equates to a forward PE ratio of 15.1 versus a long-run average of 13.5). Relative to interest rates, however, the market is still on the cheaper side of fair-value, with the differential between the forward-earnings yield and 10-year bond yields at 3.8% versus a long-run average of around 2.5%. Of course, helping market valuations is the fact that 10-year bond yields remain unusually low at around 2.9% versus a long-run average of 4.85%.
Fundamental Outlook – earnings
The biggest challenge for the market, however, remains the earnings outlook. As seen in the chart below, the median consensus analyst estimate (according to Bloomberg) for earnings in the current and following financial year (FY’16 and FY’17) have continued to be revised down over the past month – not helped by further weakness in commodity prices. The recent drop in iron ore spot prices to below $US40 tonne – which even the Federal Treasury now expect will persist through this financial year – should result in more earnings downgrades in the resources sector.
The market remains challenged both technically and fundamentally. Technically the market remains vulnerable to further weakness, with the S&P/ASX 200 Index establishing itself below the 200-day moving average and failing to mount a convincing rally over the past month.
Fundamentally, earnings in the resource sector in particular seem subject to further downward pressure, while PE valuations in the sector have also moved to above-average levels. Usually, that’s a sign investors expect the period of earnings weakness to be only temporary. But if commodity prices stay low, resource sector earnings are unlikely to bounce back anytime soon which could pressure current elevated valuation levels. Perhaps somewhat surprisingly in view of the recent debate over bank valuations, outright forward PE levels in the financial sector are close to their long-run average.
Investors wishing to express a bearish view with regard to the Australian share market can do so using our Australian Equities Bear Hedge Fund (ASX: BEAR) or Australian Equities Strong Bear Hedge Fund (ASX: BBOZ). The Bear Fund seeks to generate returns that are negatively correlated to the returns of the Australian share market (as measured by the S&P/ASX 200 index), while the Strong Bear Fund seeks to generate magnified returns that are negatively correlated to the share market.
The Funds operate in such a way that a 1% fall (rise) in the broad Australian share market on any given day can be expected to produce between a 0.9% to 1.1% rise (fall) in the net asset value of the Bear Fund (before fees and expenses), and between a 2.0% to 2.75% rise (fall) in the net asset value of the Strong Bear Fund (before fees and expenses).
Please note: The Bear and Strong Bear Funds’ strategy of seeking returns that are negatively correlated to market returns is the opposite of most managed funds. Also, gearing magnifies gains and losses and may not be a suitable strategy for all investors. Investors in geared strategies should be willing to accept higher levels of investment volatility and potentially large moves (both up and down) in the value of their investment. Geared investments involve significantly higher risk than non-geared investments. Investors should seek professional financial advice before investing, and monitor their investment actively. An investment in either of the Funds should only be considered as a component of an investor’s overall portfolio. The Funds do not track a published benchmark.