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(August-2004) So far so good, but let’s not get cocky
Last year to June 30 was the year of recovery for the global share markets, with a particularly robust recovery in Australia.
Returns of 21 per cent were achieved,in-line with global shares. Of note was the return of experienced investors to the market. All good news for share owners and investors.
Now is a good time to ask if this is sustainable and what should be the strategy going forward.
Already, major markets have shown signs of consolidation. It is my view that while 2003-04 was a tremendous year, next year should be a time for caution and disciplined investing.
The main driver of the recent rally was the global economic turnaround brought about by substantial monetary and fiscal stimulus in major economies. For example, the consistently low global interest rates and tax cuts in the US.
Resource stocks such as BHP-Billiton recovered very strongly as investors anticipated higher commodity prices due to news of a more robust-than-expected economic recovery in the US and continuing strong demand from China.
Low interest rates allowed listed property to continue its extraordinary 10-year bull run. Technology stocks recovered somewhat from the mire of the previous two years as corporate earnings proved unexpected resilience and IT spending bounced back.
Consumer spending was also a factor in maintaining the momentum in earnings growth. Small capitalisation stocks enjoyed resurgence and capital raisings were plentiful and increasingly well supported.
However, overall the rally was driven by a simple re-emergence of investor optimism.
After several difficult years, the market ‘wanted’ to rally, and while interest rates helped a much-anticipated cyclical upswing, broad indications of inflation remained fairly benign. Investor sentiment and attitudes to risk clearly changed.
However, there still seems to be little sense of jubilation from investors despite the recent healthy returns.
A number of seemingly obvious factors may be contributing to an anomalous psychological balance between investor relief about 2004 and self-doubt about 2005.
These fundamentals are based mainly on the possible effects from the emergence of expectations for higher inflation requiring central banks to lift interest rates and placing pressure on asset values that may be at cyclical highs. It is a fear of the future.
For example, any sudden government induced slowing in economic growth in China will slow future commodity demand in Asia, and this will hit resource stock earnings.
A strong Australian dollar should hit export volumes and, added to that, is the timing of consumption and wealth impacts from a deflation of the housing boom. These will be critical.
How these interrelate and actually play out is not easily predictable and, while markets may go higher in the short term, prudence suggests that expectations should be for lower returns in the next year. Banks, property trusts and building materials may be vulnerable in this environment.
The interest rate cycle has clearly turned. There is also a general agreement that share valuations remain well ahead of the long-term trend and earnings forecasts have been revised upwards.
While share markets can trade for a considerable time as over or under-fair value, a correction must occur. If the present price momentum does come out of the market, ‘valuation’ disciplines will become the critical defensive strategy.
It may become increasingly important for investors to focus on how underlying economic drivers correspond to sustainable levels of market value.
Any growing perception that currently accepted market price earning multiples place too high a premium on economic stability and a low inflation environment may see a shift to less resilient stock prices.
The make-up of the domestic market, related to developments in the listed property sector and to News Corp, and consequent increase in banks index weightings should have some effect on the portfolio decisions of investors in 2005.
A highly concentrated property sector may have increased risk and less appeal. This may be reinforced by News Corp becoming a foreign stock and with banks becoming an even more dominant sector in the market.
This year was a great vintage year for shares but I believe 2005 will see lower returns overall.
I don’t sense a feeling of urgency from investors about the eminent timing of this possibility and it may not therefore be currently priced into equity markets.
In short, the economic and market optimism may be justified but after such a good run, a cautious stance is probably more appropriate.
— Guy Hutchings is chief investment officer, Tower Australia
AUTHOR
Mike Taylor
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