As was the case last year, it is hard to see 2016 being anything other than a stock pickers market. Due to stretched equity valuations and a sluggish corporate earnings outlook, chances are that overall price growth for the Australian market will be fairly muted.
In 2015, the S&P/ASX 200 index produced a grossed up return of only 2.6%. In turn this reflected a chunky 4.7% grossed up (i.e. allowing for franking credits) dividend return, partly offset by a decline in prices of 2%.
Why did prices decline? It was not because of a decline in the PE ratio. The price-to forward-earnings ratio in fact edged up from 14.7 to 15.6. On an outright basis, that’s pricey considering the PE ratio as only averaged 13.5 over the past decade or so, and has rarely traded at anywhere near 16 without suffering an corrective pull-back in prices.
To some extent, valuations rose due to still relatively low interest rates. With Australian 10-year government bonds ending last year at only around 2.9%, the forward earnings yield (inverse of the forward PE ratio) to bond yield gap edged down to 3.5% – which is still higher than its average since 2003 of 2.5%, but a bit below the 4% average since the peak in commodity prices in mid-2011.
But the other factor likely holding up valuations is the notion that Australian corporate earnings weakness could be temporary. Indeed, forward earnings for the market actually declined by 8% through 2015, missing earlier market expectations for double-digit earnings growth by a large margin. Collapsing commodity prices and mining sector earnings were the main culprits.
But with commodity prices expected to stay low in 2016 – and possibly fall further – it’s hard to envisage a major earnings turnaround anytime soon. Indeed, assuming further a modest further earnings downgrade, my best guess is that forward earnings will be close to flat this year.
To get a decent rise in the market absent decent earnings growth, valuations will need to push higher. But as noted above, it’s a big ask to expect the forward PE ratio to push much beyond the elevated levels as at the end of 2015. That’s especially so with the United States likely continuing to lift interest rates this year provided the US economy does not tip into recession – which in turn should push up bond yields modestly further.
And if the US did fall into recession, we can stop worrying about valuations as a further collapse in local earnings expectations would be more important.
All up, the Australian market has lifted in recent years due to the rise in valuations brought about by low interest rates. Although prices moved sideways last year, PE valuations remained elevated due to weakness in earnings. Our market will likely remains sluggish until there is a decent turnaround in the earnings outlook – and this must await a decent turnaround in non-mining sectors of the economy, and a clear bottoming in commodity prices. I won’t hold my breath.
In the meantime, savvy investors will need to pick selectively. Given low official interest rates and in the absence of broad growth opportunities, I suspect decent dividend paying companies and high yielding exchange traded fund (ETFs) will remain in good demand. Offshore markets less exposed to the commodity implosion will also be favoured, exposure to which is now also easily obtained through ETFs. Note, moreover, if the $A keeps falling (as I suspect) it will add to the returns on unhedged investment in foreign markets.
Last but not least, more defensive (and decent earning) sectors such as health care should also do well, as will companies in the tourism and education sectors thanks to the more competitive $A.
