Don't Be Fooled By Appearances
May 2017 has pushed equity indices in Australia back to levels last seen in March and February, erasing in full the April advance, but as has been the case on so many occasions in years past, face value index movements are not telling the full story of what is happening inside the local share market.
What is clear is that Australian equities have found the going tougher than most international peers, with indices poised for a negative performance for the month, even including dividends. Traditionally, June is often weaker than May, so there could be more downside in store.
Look more closely though and you'll discover the Big Four Banks in Australia are having an absolute horrid time since peaking at the end of April-early May. Since then, and in only four weeks, ANZ Bank ((ANZ)) shares are off -16%, Westpac ((WBC)) lost -14.5%, National Australia Bank ((NAB)) a smidgen over -14% and CommBank ((CBA)) a little over -10%.
Even considering three out of these Big Four paid out half-yearly dividends over the period, it is clear banks in Australia are doing it tough. With a combined ASX200 index weight of circa 27%, a lot of the index's sluggishness in May can be traced back to the Big Four Banks.
This month's rapid decline from what looked like elevated bank valuations in April rekindles memories of a similar turning point almost exactly two years ago. Back in 2015, banks remained in strife, and their share prices in a downtrend for much longer.
Not that past experiences can simply be copied and pasted into today's situation and extrapolated into the months ahead, but it appears a fresh bad news cycle has opened up for the Big Four, and investors don't want a bar of it.
The big falls certainly make the banks share prices look attractive again, with implied yields rising to between 5.5% (CBA) and 6.5% (NAB) on FY18 estimates, ex-franking. Share prices cannot fall forever, and they won't, so a bounce surely must be on the cards soon. This does not automatically translate into sustainably higher share prices in the weeks or even months ahead.
Recent research conducted by Shaw and Partners suggests historically, there is a close relationship between the direction in domestic property prices and banks share prices.
With investors attention firmly focused on expected weakness in the domestic housing cycle, it is likely banks might be facing much stronger headwinds for longer.
Whether investors should fret about the banks and their share price performance comes ultimately down to the composition of their investment portfolio. Most professional fund managers who track the index, and there are many of those around, own plenty of shares in the banks, and so too the overwhelming majority in SMSF portfolios.
Most importantly, there is an argument to be made the banks' resurgence in late 2016 was predominantly macro-driven (the "reflation trade"), while their fall from grace this month is almost entirely domestic sector-specific. Banks are operating in a low credit growth environment and the risk is that, soon, important tailwinds such as the repricing of mortgages and extremely low bad and doubtful debts might turn.
This opens up a much broader question: are we back to sluggish to no growth for Australia's large cap stocks?
Macquarie strategists, for one, recently asked the question and their response was a resounding: yes, we think we are. Think bad news cycle for the banks. Idem dito for the telecom sector. Growing headwinds for consumer spending is surely going to make life tougher for Wesfarmers ((WES)) and Woolworths ((WOW)), and their second derivatives in the form of Westfield ((WFD)), Scentre Group ((SCG)) and Vicinity Centres ((VCX)).
Bricks and mortar retailers are out of favour. So too are health insurers, autodealers and property cycle exposures. Energy stocks remain captive to OPEC intentions and shale gas production in the USA. Mining stocks rely on China not tigthening too much, and providing extra liquidity when and where necessary.
It is not too difficult to paint a picture whereby investors start chasing unquestionable, robust growth stories - again. However, with a few rare exceptions, like CSL ((CSL)), Transurban ((TCL)) and Aristocrat Leisure ((ALL)), such profiles are rather rare in the top segment of the ASX.
Does this mean investors will go back where they left off prior to mid-2016 when the global reflation trade started to kick in?
Macquarie certainly thinks so. In a recent strategy update, titled "Back To The Future", Macquarie strategists state:
"We think the market is at an inflection point that will drive a more sustained period of growth stock outperformance and in turn begin to arrest the underperformance of small and mid-cap stocks vis-à-vis large caps. We think a replay of 2015 is beginning to unfold — buy growth.
"Conditions are falling into place that will make expensive stocks even more expensive, in our view. We see 'growth at any price' making an even stronger comeback as the quantum of stocks that will outperform narrows on the back of the ripple effects from a slowing consumer."
Certainly, price action in April and May supports the Macquarie prognosis. As bank share prices peaked, and subsequently tumbled, medium size growth stocks jumped back to life. Think Altium ((ALU)), NextDC ((NXT)), REA Group ((REA)), Webjet ((WEB)), and numerous others.
Meanwhile, those High PE growth stocks everybody wants to own, but rarely does because valuations are deemed (too) expensive, simply have kept on rising. Cue Corporate Travel ((CTD)), Treasury Wine Estates ((TWE)), Aristocrat Leisure, WiseTech Global ((WTC)), etc.
The FNArena & Vested Equities All-Weather Model Portfolio has been a beneficiary of this below-the-surface dynamic too, enjoying solid gains over the past three months, including in May, as market momentum shifted away from banks and consumer oriented stocks.
The gap in performance between miners and banks and the high quality, cycle agnostic industrials that populate the All-Weather Model Portfolio has narrowed significantly post February from the late 2016 slaughterfest that was inspired by the election of Trump and the Global Reflation Trade that has since come to naught.
As such, we are very sympathetic to the Macquarie view, believing there remains plenty of upside for the likes of CSL, Amcor ((AMC)), Link Administration ((LNK)), NextDC and Technology One ((TNE)), irrespective of premium valuations and share price gains already achieved.
The Portfolio's performance in recent weeks is even more impressive if one considers seasonal and macro-risks have kept our cash component close to 30%, at times even higher. In hindsight, our cautious approach has somewhat limited the portfolio's performance, but such is our wont. We're in this quest for the marathon experience, while protecting the capital of our investors, not for the short term glory.
We have used the opportunity to exploit a few share market anomalies, including adding Viva Energy ((VVR)) to the Model Portfolio following the company's positive market update in May. We consider Viva Energy a robust, inflation resistant, sustainable dividend payer whose share price is only now trading up to fairer value.
While our initial stake is relatively small, we'll be looking to buy more shares on future weakness, as we do for most stocks that are currently held in the Model Portfolio.
In line with my personal market research and analysis, the All-Weather Model Portfolio invests with a medium to long term view in high quality, durable growth stories among industrial companies, accompanied by multi-year growth stories presented by emerging smaller cap stocks. Examples of the first group include CSL, Amcor and Technology One. Paid subscribers can read up on my research, and follow these stocks via a dedicated section on the FNArena website.
Examples of the latter group include Altium, NextDC and WiseTech Global. The high and robust multi-year growth outlook for these companies comes with High Conviction attached.
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