Equity Strategy: Is Australia Overvalued?

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– PE expansion driving ASX200
– No end in sight to yield demand
– Oz stocks on firmer footing
– 6000 to be breached

By Greg Peel

There is little question, Macquarie suggests, that over the last three months the Australian stock market has been driven predominantly by “PE expansion”.

PE expansion occurs when the share price numerator of a company’s price/earnings ratio (PE) increases but the earnings denominator does not increase to catch up. PEs are driven higher on investor demand and positive sentiment rather than the fundamental driver of earnings growth. When PEs rise too far above historical averages, markets are over-valued and at risk of a pullback.

It’s not hard to identify just where recent investor demand has been coming from. The relentless quest for yield in a low interest rate world has overcome the drag in an Australian market dominated by resource and resource services stocks suffering from low commodity prices. The RBA’s rate cut in March, coupled with a growing belief the Fed will undertake its first rate rise later rather than sooner in the year, has added further fuel to the yield-seeking fire.

However Macquarie’s analysis suggests that while PE expansion has been the primary driver, there remains a modest positive contribution from actual earnings growth momentum. There is indeed a long list of stocks for which earnings upgrades have driven outperformance. There is also a basket of stocks which have seen their PEs fall, Macquarie notes, despite forecast earnings upgrades.

In the latter camp are Amcor ((AMC)), Westfield Corp ((WFD)), Caltex ((CTX)), Computershare ((CPU)), Lend Lease ((LLC)), Veda Group ((VED)) and Steadfast Group ((SGF)).

On the other side of the coin, there are a number of stocks that have run hard on pure PE expansion despite earnings momentum actually being negative. These stocks are at risk of de-rating if earnings expectations cannot be met, Macquarie warns.

That list includes QBE Insurance ((QBE)), Graincorp ((GNC)), AGL Energy ((AGL)), Coca-Cola Amatil ((CCL)), Nufarm ((NUF)) and GUD Holdings ((GUD)).

When last Macquarie updated its forecast for the ASX200, the broker projected a level of 5876 by September, 2015. At the time this represented a 6% rise, but instead the market has risen 11% and has traded above this level for most of the past few weeks thanks largely to the RBA rate cut.

Updating its one-year forward forecast sees the broker predicting an index level of 6068 by March, 2016. This would represent 8.3% total shareholder return, comprised of 3.5% capital value increase and a 4.7% dividend yield. While resources have proven a big drag on returns up to now, Macquarie is forecasting a rebound ahead that would see an 8.4% total shareholder return for the sector over the period.

But the broker anticipates some further near term weakness as commodity prices, meaning iron ore and oil, find a floor.

The broker also suggests the ride to 6068 will not be a smooth one, and investors should expect volatility driven by the first Fed rate hike, as well as potentially the Greece issue and tensions in the Middle East.

The ASX200 has on three occasions this year attempted to push through the 6000 mark, only to retreat again. The first attempt was in February, and Credit Suisse believes Australian stocks are on a firming footing today than they were back then. Balance sheets are stronger, valuations are more attractive, cash rates across the globe are low and falling and new capital raisings have been few and far between. Without IPOs or secondary raisings, the local equity market has no outlet to soak up considerable demand, the broker notes.

Credit Suisse is thus more bullish than Macquarie, raising its own ASX200 end-2015 forecast to 6500 from 6000 previously.

The broker does not believe the dividend trade – the driving force behind the Australian market – has yet run its course. Australian stocks will continue to attract demand from savings pools seeking income both locally and internationally.

Those stocks currently providing a dividend yield premium to international peers of 50% or more, notes Credit Suisse, include Macquarie Group ((MQG)), Fairfax Media ((FXJ)) and Sydney Airport ((SYD)). The broker has just added Sydney Airport to its preferred long portfolio.

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