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.

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