Is it 2004 or 2008 revisited?

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By Shaun le Roux of Alphen Asset Management.

Since just over a year ago, the price-earnings (PE) ratio on the  FTSE/JSE All Share Index (ALSI) has more than doubled – from a low of 8 times earnings in March 2009, the stock market now trades at 18 times.  In other words, in just over a year the rating of the market has more than doubled.

Over this period, the ALSI has returned 65% and a staggering 142% in dollar terms.

A trailing or historic PE ratio of 18 is just about as expensive as the JSE gets.  But, it is important to note that this is based on past earnings, and because we are on the cusp of a strong earnings recovery on the JSE (we expect  34% profit growth over the next 12 months), the PE ratio will unwind substantially to just over 13 times as earnings come through.  This 12 month forward PE ratio is not far from the average forward PE over the past 20 years.

If the JSE is not excessively expensive after taking into account earnings expectations over the next year, the call on how attractive equities are is really based on what comes thereafter.  Remember, stock markets are forward looking.

If the JSE repeats its profit growth performance of the 2004 to 2008 period, when earnings grew on average by 25% per annum for four years, this market has much further to run. In fact, at current valuations many stocks look to us like they are starting to discount exactly this scenario, the domestic cyclicals in particular.

We are somewhat skeptical that the JSE can repeat its 2004 to 2008 profit cycle and hence share price performance. Sure, hefty interest rate cuts should now be supportive of consumption as they were in that period.  But, it is very difficult to see a repeat of the credit binge we saw then.  In fact, many South Africans still find themselves under extreme pressure thanks to the excess credit they were granted in 2006 and 2007.

Global economic growth is bouncing back strongly and corporate profitability will follow.  That said, we favour a structurally lower growth scenario over the next several years.  We cannot see domestic or foreign economic growth rates coming close to the 2004 to 2007 levels given the lower demand for credit worldwide and the de-leveraging of balance sheets in the personal and financial sectors.   Global government debt levels do not have capacity to expand much further without incurring significant stress, so this source of stimulus is starting to get tapped out.

If we view the 2004 to 2007-type profit cycle as being unlikely, what should one expect?  Here we are looking for profit growth much closer to nominal GDP growth of say 8% to 12% in South Africa, once we have had the sharp recovery off a low base which we are currently experiencing.

Moderate levels of profit growth and a relatively rich rating for the stock market mean that investors should be factoring in much more muted returns from equities over the years ahead, particularly when compared to the bull market of 2004 to 2008.

The problem is that the market is currently in melt-up mode, and this is where it feels eerily like early 2008.  At the time, there was strong momentum in equities, emerging markets and commodities, and as prices moved higher, they attracted more money.

So, the jury is out.  Will we see a 2004-type robust growth cycle that will see further strong gains from equity markets?  Or, will the market continue to melt-up like it did in the first half of 2008?  The answer probably lies somewhere in between.  The profit cycle will be more muted and hence returns lower, but carefully selected equities will provide reasonable returns.   Extra-special care needs to be taken to avoid the over-priced securities that could result in capital losses.

Given the very low level of interest rates that are prevailing worldwide, it looks to us like the path of least resistance for equity markets remains to the upside.

Our investment strategy is to sell into strength as the market moves higher.  We expect to get an opportunity to employ the cash over the year or two ahead.  We are very careful to own stocks that are not pricing in a fairytale profit scenario and our strong preference is for value.

Source: Shaun le Roux, Alphen Asset Management, April 14, 2010.

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