From peak to recent trough, the decline in the Australian share market over recent months has been 16.5% – or very close to the “bear market” definition of a 20% decline. To my mind, we will likely see stocks dragged somewhat lower before this period of corrective market activity is over – we will, as least definitionally, tumble into a bear market.
The good news is that there’s a very small risk in my view of anything like the 50% crisis-inspired slump of 2008, and I suspect the market will be staging a decent recovery by at least early 2016.
But if I had to guess, I’d say the market is at best only two thirds of the way through its correction – suggesting the overall correction might be closer to 25% or an S&P/ASX 200 index level of 4500.
While will the market fall further? For starters, the decline to date as only pulled the S&P/ASX 200’s price-to-forward earnings (PE) ratio to around 14.5X, versus a longer-run average of around 13.5x. That’s lower than the nosebleed 16x earnings valuation earlier this year, but still comfortably above the lows of around 9x and 10.5x at the last decent market bottoms on early 2009 and mid-2012.
Consider the following back of the envelope calculation: assuming local 10-year bond yields hold around their current level of 2.6%, then to generate a 6% earnings-to-bond yield gap would require a forward earnings yield of 8.6% – or a forward PE ratio of 11.6x – or a whopping 19% below the current PE ratio.
The PE ratio could also fall though a rise in earnings. But over recent months earnings expectations have been downgraded (due to weak commodity prices) – and forward earnings have in fact been falling modestly, rather than rising. Assuming flat forward earnings, then a decline in the market to around 4500 would imply a forward PE ratio of around 13 – or slightly below its long run average. If bond yields held at 2.6% it would also imply an earnings to bond yield gap of 5%.
All up, while a correction to 4500 might seem ugly, it would still imply a bottom in valuations somewhat better then at in early 2009 and mid-2012.
So far so bad, but why am I optimistic the market will eventually turn around? That’s because barring another financial crisis emanating from some dark corner of the global financial system, the positive macro-economic news is that global inflation remains low and central banks could still prime the punch bowl through further rounds of quantitative easing if need be. That will not be required in the case of the United States, where the economy appears to retain good momentum. And even in China, the slowdown underway appears orderly and manageable.
But in the case of Australia, the Reserve Bank clearly has capacity to cut interest rates further. And the Australian dollar is again demonstrating its capacity to flexibly adjust to our changing economic requirements. If the RBA cuts interest rates to 1.6% by mid-2016 – as I still expect – and the $A eventually drops to $US65 by that time, I suspect that will be enough of a macro-boost to eventually lead to earnings upgrades and a stronger, better balanced, economy.
The next few months may not be easy, but I do see some light at the end of the tunnel.
