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Share market gyrations no cause for concern

David Bassanese
Wednesday, August 26, 2015

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By David Bassanese

So markets have broadly come back to fair-value, but they are still not the compelling buy they were at the bottom of the last decent market pullback in mid-2012.

What are we to make of recent global stock market gyrations? Clearly, there is a lot of negative news that investors are able to cite in order to explain the recent pull back in equity markets around the world.

For starters, the United States Federal Reserve – at least up to the recent market meltdown – seemed to be inching closer to raising interest rates for the first time since the global financial crisis. Investors are understandably nervous, as history suggests equity markets usually sell off in the first few months following the start of an interest rate tightening cycle.

Then there’s the melt-down in Chinese equity prices. More worrying is the fact Chinese officials could not stop the bloodbath, despite some very drastic market supportive measures. And China’s decision to devalue its currency also reeked of desperation, and led to speculation we could be entering another Asian financial crisis generated by competitive currency devaluations across the region.

My base case view, however, is that this is more a buying opportunity – for those with the appropriate risk appetite and spare cash – than a time to head for the hills. That said, it’s probably a little premature to think that the recent bout of volatility is over.

Recent market gyrations suggest price volatility is likely getting higher – perhaps through the growing use of mechanical program trading around the globe. This means non-program traders – such as average Australian investor - need to develop even greater intestinal fortitude.

Why do I remain cautiously optimistic?

Let’s look at the big picture. Interest rates and inflation globally are still quite low – and will remain fairly low even as the Federal Reserve begins to gradually raise official interest rates from currently near-zero levels.

What’s more, we’re still shaking off the GFC, and so there remains ample global spare capacity for above-average global growth without generating worrying consumer-price inflation anytime soon. That means if they need to – and let’s hope it won’t have to – the Fed could easily embark on yet another round of quantitative easing.

Rising commodity supply and the ongoing internet/information technology revolution are also “positive supply side shocks” that can support global growth and keep inflation low. I see low global inflation as not a source of weakness and a reason to worry – but a source of strength and resilience.

The US economy is still broadly recovering, and China – while it may not be able to control the share market – does retain enough policy levers to support economic growth if need be. China overnight announced a cut to official interest rates and bank reserve ratios – and there is likely more of this to come. Some Chinese housing indicators have also turned more positive in recent months.

As for another Asian financial crisis, most countries gave up trying to control their currencies long-ago, and their financial systems today are much more robust.

Of course, this optimism does not necessarily mean commodity price won’t keep falling, and some emerging economies are vulnerable to more market instability as US interest rates (eventually) rise. Commodity prices – and the $A – still appear in a secular downtrend. But this is as much about rising global commodity supply, as weakening global commodity demand.

My optimism also doesn’t mean equity prices can’t sell off – even for a few months.

The major reason I think equity markets have corrected in recent weeks is because valuations became overly stretched and – as is typical in these environments – were looking for excuses to sell off.

As seen in the chart below, the price to forward earnings ratio in both the US and Australia markets had blown out to the top end of their range over the past decade.

While equity markets were not as expensive relatively to (unusually low) bond yields, these stretched PE valuations had understandably made traders nervous about pushing prices ever higher – especially with Fed likely to hike rates soon.

It’s also true that US forward earnings had flattened out earlier this year, after a stellar run since the GFC ended in 2009. US forward earnings have resumed their uptrend more recently. Sadly, forward earnings in Australia have been weak for some time – which also highlights (along with the weakening $A) the importance of seeking international diversification. 

Based on their latest prices, the S&P/ASX 200 and S&P 500 indices are now trading around forward PE ratios of 14.5 and 14.8 respectively – which is better than they were but still a little above their longer-run average (since 2003) of 13.7 and 14.2.

So markets have broadly come back to fair-value, but they are still not the compelling buy they were at the bottom of the last decent market pullback in mid-2012. An optimist might suggest that Wall Street’s recent weakness means it has already priced in Fed tightening – that may be true, but I would not count on it.

All up, unless you are investing in the Chinese stock market, my advice would be to ignore it and focus on Wall Street and Chinese economic indicators instead. These will provide a better guide to the health of investment markets.

Finally, my base case view is we’re likely to see more market volatility ahead though this should not (and probably will not) stop the Fed from raising interest rates before year end.

Published: Wednesday, August 26, 2015

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