Three risks to ponder as the festive season approaches

With year-end approaching and equity markets having positively surprised thus far in 2021, the risk is investors become overly complacent, thinking nothing can possibly disrupt this year's uptrend given most calendar years end on a positive note.

It's always good to keep in mind a positive finish to the year is not a given, as also highlighted by recent analysis published by CommSec confirming December has posted a positive return of 1.9% on average over the past 70 years, but with only 50 out of the 70 months closing the calendar year with a positive return.

On that basis, there is a 28.5% chance December may not deliver this year, while the odds, historically, are a lot worse for the remainder of November.

Besides, after a gain of 16%-plus ex-dividends since 1 January, and almost 27% ex-dividends over the past 12 months, maybe this is the most opportune time to start looking towards 2022 and specifically at the potential risks ahead.

Note also, the ASX200 has effectively been treading water since August with both September and October posting a negative performance.

While there is always the chance of an unpredictable event, ie, the proverbial black swan, I believe global equities are currently facing three key risks: valuations, inflation and bonds, and corporate earnings. 

It's time to have a closer look at each.

Share market valuations are high

Whether valuations are now dearest since the dotcom euphoria of the late 1990s-early 2000 or not, it is hard to argue with the observation most equity markets are far from cheaply priced these days, and I am probably formulating it mildly.

Every day, just about, I hear or read the term 'bubble', though that hasn't, thus far, stopped markets from powering higher.

Underlying, this story hasn't changed much over the past 5-6 years or so with growth stocks and dependable, quality performers attracting most of investors' attention, and funds inflows, hence the gap between market leaders and the laggards among cyclicals and value companies remains large, if not very large, by historical standards.

At face value, and as reported by many, the past 12 months embody the relative come-back of value vis-a-vis expensive growth, but don't be fooled by the generalisation. Most of the 'expensive' industrials have resumed their relative outperformance since March and upward momentum is ongoing as 10-year bond yields retreat from earlier (premature) inflation anticipation.

We can draw a direct correlation with better-than-expected corporate earnings and resilience, more on that further below, but I suspect this is far from the full story, in particular in the US where indices are "melting upwards" since late September/early October.

Consider that over the past 4-5 weeks major share market indices like the S&P500 and the NASDAQ have rallied between 9-10%, with hardly a pause along the way. I don't think we can build a credible argument that Q3 corporate profit results have been that good.

So what was really going on?

In my view, too many investors, of all kinds and stripes, had been shifting part of their portfolio into cash out of fear for a serious correction as inflation hysteria was building and bond yields the world around were moving higher.

Now that central bankers have remained on-message, the global discussion about inflation, bond markets and central bank policy-shifts hasn't ended, but overall things have settled down.

Thus calmer bond markets have led to that cash on the sidelines returning into equity markets again. All at once, at the same time, we know how that story goes. US markets have rallied the equivalent of a 'normal' year's total annual return in 4-5 weeks.

With all kinds of technical indicators flashing US markets are now 'overbought', I suspect the odds are now in favour of markets deflating somewhat.

Nothing can possibly go up every day into eternity. Of course, there is always the possibility that bad news arrives at the wrong time and pulls back market sentiment a lot further down.

US Congress will have to vote once again on raising the debt ceiling in December, to name but one potential negative catalyst ahead.

The sad observation for Australian markets is that if US equities do experience a big pull back, or enhanced volatility, the ASX won't be spared just because it hasn't melted upwards in the same fashion. Something to keep in mind for the weeks ahead.

The threat of inflation and much higher bond yields

At the start of the calendar year it was quite fashionable to forecast 10-year bond yields at 2% and beyond by year-end.

As we have only half-a-dozen or so weeks left until preparations start for family gatherings under the Christmas tree, it seems rather unlikely 10-year yields in Australia or the US will meet those predictions.

Inflation the world around has surprised to the upside, but most central bankers have stoically stuck with their assessment that most factors underpinning price inflation in 2021 are "transitory".

Either way, they intend to remain cautious and patient instead of running the risk of prematurely killing off the economic momentum post-pandemic.

Bond yields in the 2-3 years timeframe might not subside anytime soon as financial markets will continue to speculate on central banks (possibly) being forced to pull forward their first rate hikes, but yields on 10-year bonds are much more important for equities, and those yields are retreating in November.

In the US, the 10-year yield peaked in March at 1.74% and it hasn't been seen near that level since, while yields on both the 20-year and the 30-year have pulled back quite sharply since that time to 1.90% and 1.89% respectively, marking an inversion of the curve at the long end.

Both the lower 10-year yield and the long end inversion have many experts flummoxed.

Could the answer be found in commodities and related markets where, for example, the Baltic Dry Index (often used as a gauge for global demand for goods and materials) has quickly fallen 50% off its peak, after earlier rallying parabolically throughout the calendar year?

At the very least, such a fall suggests the post-reopening bottlenecks for international cargoes are becoming less severe. Does this indicate less inflation pressure because of normalising, ie, lesser, demand?

Market prices for pork bellies, corn and soybeans are all down double-digit percentages in the space of a few weeks, and we already know full well the price declines for lumber and iron ore are larger than for the Baltic Dry Index, but then recent price declines for aluminium, zinc and copper are equally larger than 10%.

Maybe the message here is that while inflation represents a potential problem for the immediate term, the real question mark concerns global growth and demand resilience further out?

That certainly seems to be but one logical conclusion to draw if we combine all of the above. It cannot possibly be only about China, or can it?

This year's price action for global equities has been closely correlated with bond markets. Australian equities have underperformed over the past two months because the local bond market was more aggressive in pricing in future rate hikes than US Treasuries, for example.

If I had to define the risk stemming from bonds, I would no longer focus on the day-to-day movements, but instead on the signal that is likely being communicated by bond yields further out.

That signal says tougher times are coming; make sure you understand the message and be prepared.

Earnings forecasts: firmly in decline

Forecasts for growth in corporate profits have pretty much halved in Australia since August, which is yet another explanation as to why local indices have not kept pace with the positive momentum on US markets.

At face value, it seems all investors can expect for FY22 is some 6.5% in aggregate EPS growth. Most of the decline from August forecasts has been reserved for commodity producers and the banks, with insurers doing their bit too.

Is it any wonder Fortescue Metals (FMG) shares are now at $14 instead of $26, or that Westpac (WBC) shares are now at $22 instead of $27? Shares in Rio Tinto (RIO) are trading below $90. They reached as high as $135 in late July. Shares in Codan (CDA) have failed to recover from the sell-off post AGM update.

In light of recent corporate results in Australia, it would be easy to — yet again — point out the (sharp) difference in market updates.

Compare those updates delivered by cheap-looking companies such as Suncorp (SUN), Insurance Australia Group (IAG), Westpac, and Woodside Petroleum (WPL) — all disappointing — and the robust performances and operational updates communicated by solid, quality performers such as Amcor (AMC), Macquarie Group (MQG), ResMed (RMD) and REA Group (REA), as well as from small caps Life360 (360), Johns Lyng Group (JLG), Rural Funds Group (RFF) and Hansen Technologies (HSN).

However, price action post market updates by ResMed and REA Group suggest valuation limits might be presenting themselves, irrespective of further operational excellence.

This might well be today's investors' dilemma in the local share market: the proven and known performers are at risk of becoming too expensive, for now, while the cheaper laggards might be forced to issue the next profit warning as global conditions tighten.

I'd say, logically, all of the above seems to indicate it is time to start focusing more on the downside risks instead of further upside potential.

Confusing November

The team at CommSec has released some intriguing research into monthly share market performances in Australia.

As per general consensus, September is traditionally the worst performing in Australia with only 30 out of the past 70 calendar years showing a positive performance for the month.

Add the fact that over those 70 years, the performance for September averages out to a negative 1% and it is not difficult to see how general market perception and CommSec's data analysis meet in mutual agreement. But what is surprising is the fact that November has been called out as the second worst month of the year.

Yes. Me too. 

I was firmly under the impression that November usually lays the foundation for that traditional upswing often referred to as the Santa Claus rally, following on from the usual positive momentum that starts building throughout October. Apparently that is not the pattern observed over the past 70 years.

For good measure, the All Ordinaries index, which has been used for the analysis because it has a longer history than the ASX200, only declined once during November in the past five years, while twelve months ago the monthly return was a record-setting 9.9%.

But CommSec also reports between 2010 and 2015 the index performance ended up negative in each and every November that came along.

Spread out over the full period, the average return for November ends up as a negative 0.3%, which is why it ranks second worst on CommSec's data analysis. However, nominating November as the second worst month for Aussie equities does come with a twist or two.

Firstly, both September and June only recorded 30 positive monthly performances over the past 70 years, while both February and November have 34 (more than 10% better), but CommSec's ranking is based on the average performance over the period, which is down 0.1% for both February and June compared with November's minus 0.3% and September's minus 1%.

Secondly, according to the Stock Trader's Almanac, November is the best month of the year for some indices in the US (S&P500, Russell1000 and Russell2000), and the second-best for the Dow (DJIA) and Nasdaq since 1950 and 1971 respectively. But, explains the Almanac, November also tends to have a recognisable pattern of a strong opening, followed by an underwhelming two weeks, then a strong finish into month's end and December.

Judging from this year's price action post 1 November, the Almanac's monthly pattern might be repeated, but a lot can happen in the coming weeks.

The same Almanac also tells us November historically starts off the strongest six months period for the DJIA and the best performing eight months for the Nasdaq, as well as that when rolling 10-year returns from US equities are as strong as they have been, investors should brace for noticeably lower returns in the years following.

FNArena offers impartial and independent share market analysis, accompanied by proprietary data, tools and applications for self-managing and self-researching investors. The service can be trialed for free here.

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