The following note lays out a template (which we will update from time to time) for tracking the health of the Australian stock market from both a technical and fundamental perspective. The bottom line is 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 – for a time, due to sluggish earnings growth and challenging valuations.
As can be seen in the chart below, the S&P/ASX 200 Index has been in a broad uptrend since mid-2012. The general pattern of “higher highs” and “lower lows” marks out the uptrend, as does respect for the upward sloping trend line. The market recently touched a closing high of 5982.69 points on April 27, and recent low of 5422.49 on June 29 – marking a 9.3% pull-back. That’s consistent with our note of 5 March suggesting the market was at “increasing risk of a mid-year correction” due to challenging valuations and weak corporate profits. 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.
Fundamental Outlook – valuations
As seen in the chart below, one challenge for the market is that prices have risen since mid-2012 even though earnings (as measured by weighted-average forward earnings*) have only tracked sideways.
In turn, as seen in the chart below, that implies the market gains in recent years have largely come via rising price-to-earnings (PE) valuations. Indeed, the market’s forward PE ratio (price to weighted-average forward earnings) has lifted from a “cheap” level of 10.6 in mid-2012, to a relatively “expensive” level of just over 16 in recent months. That compares with a long-run average (since 2003) of around 13.5.
That said, since mid-2012 bond yields have only declined from around 3% to 2.75%, while the earnings yield has fallen by relatively more – resulting in the earnings to bond yield gap (which we can loosely describe as the “risk premium”) declining from quite cheap levels of over 6% to a recent end-month low of 2.9%. As at end-July, the risk premium was 3.45%, which was still a little above the long-run average (since 2003) of 2.5%. That suggests that relative to (unusually low) interest rates, the market was still trading on the cheaper side of fair value.
All up, to some extent the rise in the PE ratio since mid-2012 has been justified by the further moderate decline in interest rates and a movement in relative market valuations (i.e. compared to interest rates) from very cheap to closer to fair value. That suggests the current elevated PE ratio may be sustainable, but is crucially dependant on interest rates staying relatively low. Indeed, one upside risk for the market is that the PE ratio continues to rise – pushing the risk premium to its long-run average of 2.5% or even lower. For example, if 10-year bond yields hold around 3% and the risk premium declines to 2.5%, the PE ratio could rise to 18.2. At current forward earnings levels, that would imply a price level of 6400!
Fundamental Outlook – earnings
Apart from outright PE valuations, another challenge for the market is 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 lower in recent months – not helped by the steep decline in commodity prices. Although FY’17 earnings are still expected to be higher than FY’16, there’s little sign yet of a stablisation in the earnings downgrades.
All up, the major upside risk in the current market climate is that the PE ratio continues to rise given that equity market valuations compared to interest rates are still cheap compared to their long-run average. A stabilisation in earnings expectations would also allow forward earnings to rise by almost 10% over the coming year. That would be a heady combination.
On the downside, however, there is the risk that bond yields could rise as the United States Federal Reserve begins the likely process of raising official US interest rates next month. Another negative is the risk of further earnings downgrades – due to sluggish domestic economic growth and weak commodity prices – which leave the path of forward earnings sluggish. A weaker $A, however, offers some upside support to earnings given net balance of exporters among major listed companies.
In my view, the most likely scenario is more sideways market action with traders reluctant to push outright PE valuations much beyond current levels and earnings growth still broadly flat.
*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.