The trend is still our friend
The ASX200 Accumulation Index, which combines share price appreciation with dividends paid, closed off FY21 with a total return of 27.80%.
It wasn't the best performance ever, also because back in 2007, the average dividend yield was higher, but eleven months of the twelve posted a positive return and every market veteran will assure us: this had never happened before.
Indeed, past data analysis conducted by Bell Potter's Richard Coppleson revealed the best index performances in terms of number of positive monthly returns post 1993 had previously stopped at ten out of twelve. In the past 28 years only FY07 managed to post a better result, delivering 28.66% in total for investors.
As is standard practice, that formidable index performance was achieved amidst continuous calls for "too much investor exuberance", "excess liquidity and cheap money-inspired bubbles" and predictions the next Wile E Coyote experience surely must be around the corner. It's only a matter of time!
I have steadfastly believed such criticism to be misguided. Firstly, because financial markets look ahead and what they see is a sharp economic recovery, albeit not in a straight line, underpinned by supportive governments and central banks. Most importantly, however, is that share prices have been supported by strong, continuous upgrades to market forecasts.
For investors there is at least one valuable lesson to be learned from the experience of the twelve months past: never bet against a market that is supported by continuous upgrades to profit (and dividend) forecasts. In Finance, it's not necessarily the actual data point that is most important, but rather the direction of the trend.
And the trend in profit projections, both in Australia and elsewhere, has thus far remained positive for ten successive months.
It goes without saying, forward economic projections and corporate profit forecasts are not the only factors that guide equity markets.
The past has shown equities can deliver a positive return even when profit forecasts are negative, and vice versa, but when corporate outlooks are supported by ongoing positive revisions, the share price usually responds to the upside, and remains well-supported.
What goes for individual shares equally applies to markets as a whole. Rising forecasts, even if they prove misguided further-out, make present day share prices look cheaper. Thanks to the strength of this year's upgrades, the local share market became less expensive even as the ASX200 added 12.90% since the start of the new calendar year.
To prove my point, investors should consider that analysts have been lifting their FY21 profit projections by between 15-20% on average for most markets. Very few indices have gained more than seems justified by those numbers. The S&P500 gained 14.9%. The average gain for developed markets has been 14.5%, when measured in local currencies. Emerging Markets, on average, only advanced by 8.1%.
In Australia, the largest improvement in profit forecasts went to the energy and materials sectors, with financials a lagging third. No surprise thus, the ASX20 has beaten all other indices in Australia over the past six months with a gain of 16.13% ex-dividends. Equally noteworthy, on assessment of Morgan Stanley, the Small Ordinaries is no longer trading at a discount to the ASX100.
The direct result of all of the above combined is that the average Price-Earnings (PE) ratio for the ASX200 has fallen to 17.5x from 20x in January and late last year. It is true, markets can become cheaper even as they rise to fresh record highs. The one sector that stands out in terms of valuations becoming cheaper and cheaper, including on relative and historical comparisons, are resources companies; oil & gas, mining and mining services.
On the one hand, this reflects the unraveling -temporarily or otherwise- of the so-called reflation trade since mid-March as global bond yields are no longer rising. On the other hand, we should never underestimate the impact of investor sentiment. Doubts have crept in and weighed upon share prices for your typical cyclicals as investors worry about slowing growth in China, but equally whether 2022 might not be a straightforward extension of the economic recovery this year.
In this context, it remains remarkable that the price of iron ore has continued its upside surprise thus far in 2021, but equally that most sector analysts remain convinced prices will reset at lower levels in the year(s) ahead. Stockbroker Morgans issued a stern warning to investors recently: when prices start declining (not 'if'), it'll be the direction of the (new) trend that counts for more than the actual data. Morgan Stanley has suggested financial results and oversized dividends in August will mark the final Hurrah! for Australia's large cap iron ore miners.
Such forecasts might still be proven wrong, but they are preventing shares for the likes of BHP Group (BHP), Rio Tinto (RIO) and Fortescue Minerals (FMG) to reach full potential. FNArena's consensus targets are currently $50.50, $135.50 and $22.35 respectively (only Fortescue is trading slightly higher) but if we were to take guidance from the bulls in the market, Macquarie and Ord Minnett, these share prices could be 30% higher next year.
Contrary to popular belief, the scepticism that surrounds the iron ore sector is widespread throughout the Australian share market. One observation in support of that statement is the fact that stockbroker's valuations and price targets are rising by less than the improvement in profit forecasts.
The second observation is that few stocks are trading above consensus price target with the August reporting season less than four weeks away. Analysts are positioning for a cracker of a season which should lead to further rises in FY22 forecasts and higher targets.
Again, those prospects are not necessarily already reflected in today's share prices. As at Monday, 5th July 2021, a little over one quarter (111) of the 434 ASX-listed stocks actively covered by the seven stockbrokers monitored daily by FNArena are trading above target. This means nearly three-quarters are still trading below target.
When I limit my data analysis to the ASX100, the percentage of stocks trading above target rises to one-third. If I concentrate on the ASX20, only four stocks are trading above target: CommBank, Wesfarmers, Fortescue Metals and -only just- Transurban.
I think the conclusion is obvious: unless analysts' forecasts are completely out-of-whack with reality for the year(s) ahead, this is not a share market valued to the absolute maximum. Far from.
Citi analysts, for one, don't think analysts' forecasts are unrealistic. If anything, their top-down analysis indicates current EPS growth projections for FY22 in the US, and elsewhere, are still too low. It is their view that further upgrades should be forthcoming, predominantly for the cyclicals (miners, energy, etc).
This then feeds into their expectations that the value trade -cyclicals and financials- will make a come-back in the second half because share prices usually respond positively to improving forecasts. Current forecasts for average EPS growth globally sit around 39% for FY21, with anticipated growth of 10% for FY22.
Citi's top-down analysis suggests FY22 global EPS growth should be closer to 20%, or 10% above where current forecasts are.
Macquarie analysts are equally positive about EPS growth for Australian companies this year and next. On their estimates, FY21 EPS growth is running at 27%, on average, followed by 12.3% next year. Resources companies are expected to deliver 61% growth in FY21, but only 4.6% in FY22.
Macquarie too sees further potential for cyclicals.
Looking forward to the upcoming August reporting season, Macquarie reminds investors the February 2021 reporting season generated the highest upgrades to analysts' forecasts in two decades. While it appears that global cyclical momentum is now past its peak, Macquarie thinks there is still plenty of momentum left to turn August into another positive reporting season.
FNArena's own statistics on corporate results in Australia support the ongoing optimism. After the February season generated the best statistics analysts had seen in decades, the minor reporting season since has equally proved a positive experience. On FNArena's assessment, of the 49 companies that have reported financial results post-February no less than 55% beat expectations while 24.5% missed. Target prices on average lifted by 3.72%.
While the latter two data points are not exceptionally good, they are positive nevertheless. But never in the history of the FNArena Corporate Results Monitor has the percentage of "beats" come out this high. The highest percentage thus far was 49% in between August last year and February, followed by 47% of beats in February.
All of the above also suggests things are likely to become less straightforward into 2022, if not later this year. In simple terms: earnings forecasts won't be rising forever. When they stop trending upwards, and possibly start declining, they might just be the trigger that pulls down a share market that remains expensive on historical metrics.
Citi analysts suggest that moment of reflection (if we can call it that) might well arrive before year-end, at around the same time as when many an analyst expects the Federal Reserve to start talking tapering, if not talking about talking about possible future rate hikes.
Macquarie doesn't necessarily disagree, but makes the timing dependent on the pace of slowing for the global economy over the months ahead. Irrespectively, Macquarie thinks while the upcoming August reporting season should continue the positive momentum for local earnings forecasts, by February next year all the oomph might have evaporated and the number of corporate disappointments might spike a lot higher.
It is not difficult to see why many an institutional portfolio has adopted a more cautious stance recently, or why Quality stocks are making a come-back. If the expectations as expressed by Citi and Macquarie, among others, prove correct the year ahead will gradually start differing from the year past, and risk will increasingly reveal itself.
A more cautious investor will probably use the August reporting season to start making preparations for riskier times ahead. Others should be aware that trying to squeeze the maximum out of momentum won't forever be the risk-free trade it has been thus far.
In the short-term, it appears as yet too soon to genuinely worry about sell-downs and corrections. Though that time may not necessarily be too far off either.
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