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How Deep, How Long, How Far?

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Apr 09 2020

Dear time-poor reader: market analysts and strategists are trying to assess how deep the covid-19 damage will be, and for how long

How Deep, How Long, How Far?

By Rudi Filapek-Vandyck, Editor FNArena

Share market sell-offs are an emotional affair during the best of times, let alone during a Bear Market.

It should thus not surprise that since overall volatility has quietened down significantly, market commentary often involves the "is the bottom now in" question while investors are starting to feel more comfortable putting fresh money in the market again.

But what can we reasonably expect from our investments over the next eight months, and beyond? Suppose the news flow doesn't get worse, and society can soon start focusing on life post lockdowns again, is it reasonable to expect a rapid rally back to where markets were in January or in December?

Last week, Sze Chuah, Senior Investment Analyst at Ord Minnett tried to answer the question about year-end 2020 potential for the ASX200. His calculated attempt is interesting from multiple angles, irrespective of whether it proves too optimistic or not enough in the months ahead.

On Chuah's assessment, profits for Australian companies might drop by -12%-13%, but he also anticipates a rapid recovery on the basis that "As conditions normalise in the second half of the year, earnings will recover".

Simplistically, maybe, but on Ord Minnett's current scenario the drop in profits that is currently taking place throughout corporate Australia could well be compensated for over the following year, meaning profits over two years (18 months) will be stagnant, not negative.

No doubt what is feeding such optimism among market participants are the multi-billion dollar support packages announced by national governments around the world. Most of these programs are expected to be followed up with even more fiscal stimulus by the time peak corona crisis is behind us, and everybody's focus shifts to relaunching the economy.

This then leads to that other all-important question: what are investors prepared to pay for that level of profits?

This is where the public debate is raging at the moment, not just in Australia but worldwide. Those who like to take guidance from history suggest the long-term average Price Earnings (PE) multiple in Australia sits at 14.5x, which looks like a reasonable target during uncomfortable times.

On Chuah's assumptions, this puts the year-end target for the ASX200 around 5500; or not that far off from where the index is already trading at on the Monday starting the second week of April.

We still have more than eight months to work through before we reach year-end.

However, there is more than a valid argument to argue the average PE ratio can stay above the long-term average. After all, interest rates and bond yields, as well as inflation are all significantly below long term averages. All else remaining equal, this implies a higher valuation for equities is justified.

Assuming the difference translates into an average PE ratio of 16x, the average during the low interest rate environment, this places the ASX200 by year-end at 6000. That's a lot more upside potential then.

The experience from the years past, as well as during this Bear Market thus far, is that investors are prepared to accommodate above-long term average PE multiples for individual stocks as long as earnings growth doesn't turn negative.

This is one of the reasons for the large valuation gap that has persisted between, say, ResMed ((RMD)), a2 Milk ((A2M)) and TechnologyOne ((TNE)) on the "expensive" side and the likes of FlexiGroup ((FXL)), Unibail-Rodamco-Westfield ((URW)), and Star Entertainment on the "cheaper" side.

As everybody has been able to witness since February, the gap between these two groups has not closed, not even narrowed since extreme volatility hit the market.


Irrespective of whether 14.5x or 16x is the appropriate valuation multiple for a share market and economy hit by covid-19 impact, how likely is it that the loss in profits for corporate Australia remains confined to -13% while experts in the US are projecting much larger losses for American profits with some analysts suggesting -50% is not necessarily out of the question?

Given the high level of uncertainty at this stage, any kind of guesstimate comes with a high degree of uncertainty itself, but there are various key differences between Australia and share markets in the US.

For starters, the worst hit sector are oil & gas producers. While in Australia Woodside Petroleum ((WPL)), Santos ((STO)) and Oil Search ((OSH)) have become household names, their weight in local indices is quite light (less than 5% for the whole sector).

In the US oil & gas represents a substantial part of both the economy and financial markets (equities and corporate debt), in particular with a previously thriving small cap fracking industry.

Also consider that while banks, retailers and infrastructure companies are all suffering double digit percentage downgrades to earnings forecasts, a number of prominent large cap index weights in Australia have proved relatively resilient, starting with CSL ((CSL)) and BHP Group ((BHP)), respectively the largest and the third largest companies listed on the ASX.

If it wasn't for the Petroleum division, BHP Group's earnings solidity would have matched the likes of Rio Tinto ((RIO)) and Fortescue Metals ((FMG)), both index heavyweights, while relatively unaffected businesses (to date) are being managed by Amcor ((AMC)), Brambles ((BXB)), Insurance Australia Group ((IAG)), Newcrest Mining ((NCM)), Telstra ((TLS)), Wesfarmers ((WES)) and Woolworths ((WOW)); all are included in the local Top 20.

While strategists like Chuah at Ord Minnett take a generalised view to assess where the local share market might be heading, investors are being reminded that index level, direction and potential do not necessarily match those of individual stocks.

Consider, for example, that shares in data centre operator NextDC ((NXT)) are up 36% since January 1st, including a capital raising and subsequent downward correction, while shares in Ardent Leisure ((ALG)), Southern Cross Media ((SXL)) and oOh!media ((OML)) all fell between -49%-54% over four weeks in March.


Looking at the various factors that underpin the 5500-6000 range as determined by Ord Minnett, I think it's but fair to conclude the share market, by settling around the 5000 level for the ASX200, has kept a sizeable margin of safety, which allows for plenty of upside in case the covid-19 news flow turns more positive.

Not surprisingly, the more optimistic tone in risk assets recently is allowing the ASX200 to narrow the gap with the bottom of the suggested range.


Unfortunately for Australian investors, the outlook for the local share market is not only determined by what happens to Australian corporate profits and to the Australian economy, as once again proven in March when the ASX200 fell a lot more on the back of weakness in US equities.

History shows that when extreme volatility hits global risk assets, the Australian share market tends to follow the lead from US shares, while also underperforming in the magnitude of the downdraught.

In March the ASX200 index fell -21.2%, following -8.2% in February whereas the S&P500 lost -8.4% in February and only -11.1% in March. The Nasdaq did even better: only -6.4% in February and -9.3% in March.

From this perspective, it is somewhat worrying the trend in economists' projections and forecasts for corporate profits in the US remains on a downward slope. Morgan Stanley just lowered its projection for Q2 GDP for the world's largest economy to -38% annualised, beating the previously low mark set by Goldman Sachs at -34%.

Not making matters any better, Morgan Stanley now also projects the economic rebound post what will be the worst GDP result ever recorded if -38% proves accurate, will be relatively shallow. US GDP growth is not expected to return to pre-virus level until the end of 2021.

The economists' most recent update coins it the Great Covid-19 Recession, shortcut GCR. US unemployment is expected to surge to 15.7% in the current quarter, which translates into -21m jobs lost. Worst case scenarios could potentially push up these numbers to -40m and 28% unemployment by Q3.

If it turns out that Morgan Stanley has its finger on the pulse of the US economy, real GDP on an annual average basis, is poised to contract by -5.5% in 2020; the steepest annual drop in growth since 1946 when real GDP contracted more than -11%.

As the economists readily admit, the ultimate outcome will be determined by how quickly the number of coronavirus cases peaks in the country, as well as how quickly social distancing measures are rolled back, and how quickly consumer and business sentiment recovers "such that at least somewhat normal economic behavior can resume".

On Morgan Stanley's current assessment, the initial damage done to the US growth path will be much larger than during the GFC, but GDP growth should bounce back quicker; in about half the time of the 3.5 years it took from Q4 2007 till Q2 2011. Meanwhile the savings rate for the average American household is expected to jump to 11% by June from 7.9% in January.

On this basis, Morgan Stanley is suggesting consensus forecasts in the US are some 34% too high. One of the fundamental changes that needs to take place is for analysts to stop forecasting a widening in profit margins.

Even then, there still is no reason for long-lasting despair for if Morgan Stanley's forecasts and assumptions prove correct, the S&P500 might well be 9% higher by year-end (S&P500 at 2700).


Market strategists at Citi think global EPS forecasts will fall by around -50% this year; a prospect they believe is not yet reflected in equity markets. Citi has a slightly different view than Morgan Stanley in that it believes US corporate profits will prove more resilient than in other parts of the world.

What both teams of strategists have in common is that investors are being guided towards a defensive portfolio allocation while all of the above is being processed by investors, analysts and financial markets.

This means, in sector allocation terms, preferences for health care, consumer staples and communication services and (a lot) less appetite for/exposure to consumer discretionary, materials (miners and other resources) and financials.

Morgan Stanley slightly differs in its sector preferences adding financials to consumer staples and health care as most preferred exposures, while disliking discretionary retailers and technology stocks.

The added observation is that Citi does not like Australia (underweight), with an absolute preference for the US and Emerging Markets. Morgan Stanley is of the view the US economy is about to lose its status as wearing the cleanest shirt in the global laundry.

In generalised terms, while global investors' present focus is on the (anticipated) plateauing in the curve of covid-19 infections, it's good to keep in mind there is an economic recession taking place simultaneously and expectations for a quick recovery post virus peak might be a tad optimistic.

Special Note for paying subscribers: Part Two on Friday this week will line up a whole bunch of Conviction Calls and Quality assessments from multiple experts on Australian equities. Make sure you don't miss it.


FNArena subscribers have access to a dedicated section on the website on my research into All-Weather Performers.

See also my writings from the weeks past:

-Bear Market Observations

-How To Survive The 2020 Bear Market

-Global Recession Is Next

-Things To Watch, Expect, And Avoid

-All-Weather Stocks & Cash

-The Bear Market That Changes The World

(This story was written on Monday 6th April, 2020. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: or via the direct messaging system on the website).



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