I often get asked “where is the market going?” The standard answer is "no idea" or "either up or own". However, one can actually be a bit more scientific in formulating an answer. Stock market movement is simply driven by just two components:
- Movement in the overall market’s price/earnings ratio (P/E ratio)
- Earnings per share (EPS) growth
The S&P/ASX 200 Index is simply the market's EPS multiplied by the market's P/E ratio.
FY13 was a huge year for the Australian stock market with the S&P/ASX 200 Index up 17.3%. As most companies have not yet reported their full-year results, we don’t yet know actual EPS growth for FY13, but consensus estimates suggest EPS growth will fall between 3% and 4% year on year. Thus, the only reason for the market increase is that the market multiple increased from 10.8 times at 1 July 2012 to around 13.3 times at 30 June 2013.
As a generalisation, the market was prepared to pay more for stocks providing attractive income, for example, the banks. Falling earnings from resource related stocks was a material factor in the 3% to 4% market EPS decline.
The S&P/ASX 200 Accumulation Index is the S&P/ASX 200 Index plus the weighted average dividend for the market (it assumes dividends are reinvested). In FY13, the accumulation index was up 22.8%, with a dividend yield of around 5.5%.
Therefore, one needs to determine stock market performance for the coming year is to answer the following two questions:
- Will the market P/E ratio go up or down?
- Will the market EPS go up or down?
The current market P/E ratio of around 13.7 times on FY14 earnings is not unreasonably high by historical standards. The ASX market P/E ratio has averaged around 16.1 times on historic earnings during the past 30 years. The market P/E ratio is currently on 15.7 times based on FY13 earnings. Traditionally, falling interest rates and earnings growth push market multiples higher. If you believe interest rates will fall further and earnings won’t collapse, then there is a good chance the market multiple will go higher. P/E ratio expansion is not limited to Australia. A year ago, the U.S. market was on a P/E ratio of around 12.3 times and now it is more than 14 times.
Another way to look at P/E ratios is to inverse the ratio. A market multiple of 13.7 times is the same as an after tax earnings yield (the net earnings of all the stocks within the index divided by their capitalisation) of 7.3%. That is not an unreasonable figure compared with the Reserve Bank’s pre-tax cash rate of 2.75%.
Consensus EPS forecasts for FY14 are currently showing growth of 14% to 15 % compared with FY13, with EPS growth of around 26% for resource stocks alone. So, should one rely on analyst forecasts? Unfortunately, their track record last year was not great, with consensus forecasts at the end of FY13 significantly lower than the beginning of the financial year. At 1 July 2012, analysts expected EPS growth of 15% for FY13, whereas a year later they expect an earnings decline of 3% to 4%.
Use common sense in answering whether market EPS will grow in FY14. We all know the current economic climate is difficult and unemployment will likely rise, but overall it is doubtful whether conditions will be significantly worse than FY13. Many companies have incorporated cost saving programmes, while falling interest rates and the lower Australian dollar will help many company’s earnings. Yes, the earnings of many mining service companies are expected to continue falling, but few anticipate EPS declines for large-cap stocks such as the banks, Telstra, Woolworths and Coles, or sectors such as REITs, infrastructure or health care. They should make additional money on their FY13 retained earnings (after paying dividends).
Has the death of the resources and energy sectors been exaggerated, especially for large-cap stocks?
According to the Australian government Bureau of Resources and Energy Economics (BREE), completed resource capital expenditure projects during the 30 months to 30 June 2013 totalled around $64bn. BREE’s recent report shows that further projects totalling around $267bn will be completed during the next four years – $205bn for energy alone. A high portion ($189bn) is the cost of the five LNG trains currently being built in Queensland and the seven being built in Western Australia and the Northern Territory. Upon expected completion in 2015, Chevron’s three Gorgon LNG trains project alone will have cost more than $50bn. To quote Steve Marriott in Humble Pie’s live album Rockin the Fillmore, “it's all a gas”.
In its June 2013 report, BREE shows the value of resource and energy exports in FY13 to be down 8.3% from FY12, but expects overall value to be up 11.4% in FY14, despite anticipating a fall in contribution from gold, aluminium and uranium. Each major commodity is detailed in BREE’s report. Marginally weaker US$ commodity prices will be offset by the falling Australian dollar and a 4% lift in production volumes as a result of recent capital expenditure. The Grattan Institute’s June 2013 report “Getting Gas Right” expects that, as a result of current LNG capital expenditure, Australia’s LNG exports will total $53bn in 2017, up from slightly more than $15bn in FY13. BREE expects the value of LNG exports in FY14 to be up 18% year on year. This all helps explain why analysts expect 26% EPS growth in FY14 from resources and energy. It's probably too high, but it seems reasonable there will be some earnings growth from these sectors.
(Click image to enlarge)
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The above chart is interesting in that, since 2009, the S&P/ASX All Ordinaries Index has had a high correlation to the share price performance of seven companies: National Australia Bank, ANZ Bank, Westpac Bank, Commonwealth Bank, BHP Billiton, Rio Tinto, and Telstra. There is no guarantee this correlation will continue, but it does suggest these seven companies will have a significant influence on the direction of the All Ordinaries Index in FY14.
The composition of the S&P/ASX 200 Index doesn't fully reflect the underlying Australian economy and the odds seem to favour a positive outcome for the market in FY14. The main qualification is that Australia would not be immune from a new global economic crisis.
This article featured in a monthly report from Morningstar's Select Investment Research for institutional investors. Contact equitysupport@morningstar.com for more details.
