The following note updates my previous technical and fundamental analysis of the S&P/ASX 200 market index.  The bottom line is that my earlier warning that “the market uptrend that has been broadly in place since mid-2012 appears at risk of breaking down into a sideways range  – if not deeper correction” appears to have come to fruition.  With valuations still far from obviously cheap territory and corporate earnings still under downward pressure, the market seems likely to struggle for a while longer.

Technical Outlook

As can be seen in the chart below, the market’s broad uptrend since mid-2012 has been seriously challenged by recent market weakness.  In my previous market update I noted “should the market close below its recent low of 5422 points and also below its current uptrend line, it would signal the market maybe entering a more range-bound environment.”

These breaks have clearly taken place, with the recent new low 4998.13 representing a 16.5% correction from the market’s previous closing peak of 5982.69 points.  Importantly, moreover, the market has broken below the last significant closing market low of 5155.80 points in October last year, upsetting the pattern since mid-2012 of “higher highs and higher lows”.  The next level of market support would seem to be around 4655 points, which was the significant low during the mid-2013 market pull back.

Fundamental Outlook – valuations

As seen in the chart below, the recent market decline helps correct the divergence between prices and forward earnings that was evident from late 2014 to early 2015.  Over the longer-term, it remains evident the BetaShares weighted-average forward earnings measure* has only tracked broadly sideways since mid-2012 and have in fact has fallen by 8.5% since mid-2014.

As seen in the chart below, the market’s recent correction has pushed the price-to-forward earnings ratio (prices relative to the BetaShares weighted-average forward earnings measure) from an end-month closing peak of 16.2 in February, to around 14.5.  This level is still above the average (since 2003) forward PE ratio of 13.5.  Valuations on this measure, therefore, are still at a little above their long-run average (even with the market around 5000 points), and above previous valuations lows of 9 and 10.5 times forward earnings in early 2009 and mid-2012 respectively.

That said, it’s also worth noting that the forward earnings-to-bond yield differential had consistently been above this longer-run average since around mid-2011.  The average since mid/late 2011 has been around 4%, suggesting, on this basis, the market’s current relative valuation is closer to fair-value.  Note the forward earnings-to-bond yield gap is still below the peak levels of 6% achieved at the last significant market bottoms in early 2009 and mid-2012.

Fundamental Outlook – earnings

Apart from valuations, another challenge for the market remains the earnings outlook.  As seen in the chart below, the 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.

Conclusion

The market’s near term outlook remains challenged on several fronts. For starters, outright forward PE valuations are still a little above average, and far from compellingly “cheap” territory as in early 2009 and mid-2012.  Compared with low bond yields, the market’s valuations (based on the forward earnings-to-bond yield differential since 2003) are better. But even here, relative valuations are only close to fair-value if based on the average earnings to bond yield differential since 2011.

At best, only moderate growth in forward earnings (around 5%) seems likely over the coming year

In my view, the most likely scenario is more downward/sideways market action – either until such time as either Reserve Bank signals deeper  interest rates cuts and/or the $A falls a lot further – either of which could help lift business confidence and earnings expectations.  

Footnote 

*Weighted average forward earnings are a BetaShares estimate using Bloomberg consensus earnings estimates for the current and following financial years. The weight attached to current financial year earnings changes each month and is based on the number of months left in the financial year (i.e. if there are 7 months left in the financial year, the weight on current financial year earnings would be 7/12 or 58%). The weight then given to the following financial year earnings would be (100%-58%) or 42%.  As at end-June in any given year, therefore, the weighted average forward earnings would equal the expected level of earnings for financial year just about to start.