27/06/2006 - 22:00

Bargains to come, recovery next year

27/06/2006 - 22:00


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As the financial year crawls to a close on Friday, Briefcase thinks it timely to ask two simple questions. Did the stock market rise or fall over the past 12 months and, what will it do over the next 12 months?

The correct answer to the first question is up, substantially – though that is cold comfort to quite a few people in Perth, who feel a lot poorer after a bumpy ride for some of the local favourites.

The answer to the second question is up again, probably, – but with much greater care required in stock selection than has been shown during the past three years.

For the record, just about every measure you can make of share and commodity markets during the past 12 months shows substantial gains.

• The All Ordinaries index of the ASX is up the best part of 20 per cent – so much for all the hoo-ha about the 10 per cent fall since early May.

• The materials index (which incorporates most resource stocks) is up by more than 40 per cent, a staggering rise which makes the 12.5 per cent correction since the peak reached on May 12 look like a hiccup.

• Commodities soared. Copper doubled, nickel was up by 50 per cent, and even gold was up 31 per cent when measured year-on-year, and after taking into account the 21 per cent fall since May 12.

• BHP Billiton, despite its May fall, gained $10 in 2005-06 with a rise from $18 to $28. That $10 rise added a rather impressive $35 billion to the company’s market capitalisation.

Not everyone likes to look back at how markets have performed, and Briefcase agrees that what you see in the rear-vision mirror is history. The real game for investors is looking forward.

But before we do that, consider two unfortunate categories of local investors and ask how they feel about the year just ending. First, there are the late entrants, people who bought into the market in the past six months. Most of them have been scorched. Then there are the unfortunate holders of shares in stocks such as Evans & Tate (50 cents to eight cents in 12 easy months), or iiNet ($2.80 to 70 cents).

Even the faithful army of investors in Wesfarmers is wondering what went wrong with its company last year, as it slipped from $40 to $35. This slide was made somewhat easier by a capital return from asset sales, but it’s a slide that’s is asking questions of the management team that took over when Michael Chaney retired last year.

If there is value in looking at the past 12 months it lies in recognising the relative nature of movement. Put another way, whether a stock rose or fell depends on when you bought. Anyone who paid $32 for BHP Billiton on May 11 is definitely not feeling richer today, but he may by this time next year, which leads into the world of forecasting what we can expect in 2006-07.


The first point to make about the year starting on July 1 is that it is coming up off a relatively low base, thanks to the May correction, an event former prime minister, Paul Keating, would probably have termed the correction we had to have.

The 10 or 12 per cent fall from mid-May has taken the market back to a level that looks much more sustainable than pre-correction levels. In fact, it might even have made companies of quality good buying – but only if you’re a genuine investor, and not a speculator.

Explaining the next phase of the market was done very well in mid-June by the clever chaps at Goldman Sachs JBWere. In their words: “welcome investors, farewell speculators”.

In what ranks as one of the better explanations as to how markets behave, Goldman noted that three forces drive equity (share) markets – interest rates, long-term profit expectations and the “marginal investor’s appetite for risk”, with that final point easily translated as the fear versus greed factor.

During May and June, the market flicked from greed to fear as concern mounted over interest rates – a perfectly understandable position, if you’re a speculator, and probably playing the market with borrowed money which looks like it’s about to get more expensive.

Genuine investors, the category that takes a longer-term view of the world, have suddenly found themselves well placed to soak up quality shares abandoned by the speculators because:

• the profit outlook remains robust;

• market fundamentals, including prospective price-to-earnings (PE) ratios have fallen sharply; and,

• most stock markets are undervalued relative to the rate obtainable on 10-year US treasury notes.

Briefcase will not delve too deeply into the numbers crunched by Goldman to arrive at its conclusion that the next few months might be a better time to be a buyer than a seller.

But, the PE numbers are nothing short of eye-popping, partly because Briefcase is a strong believer in this simple measure of a share price (in cents) divided by earnings per share (in cents) producing the most reliable guide to valuing a stock, the PE ratio.

If Goldman is correct, the Morgan Stanley global equities measure of prospective PE multiples over the next 12 months shows a retreat from more than 23 times earlier this year to less than 15 times now.

Translated into simple English, the best measure of future PE ratios around the world has crashed.

In the US, the decline in the PE measure of the Standard & Poor’s 500 is even more spectacular, falling from north of 24 to less than 14.

Based on the current level of interest rates, the US market is estimated to be 48 per cent undervalued and the global market 71 per cent undervalued.

What happens with interest rates over the next six months is critical to the direction of the stock market, and it’s a fair bet that the central bankers of the Western world will move firmly in raising rates to kill inflation – and interest rates are critical in the stock valuing game.

But, it is a tip from Briefcase that we will see a short, sharp, attack on inflation, with the hard work done by Christmas – leaving 2007 as the start of a sustained recovery, and the rest of 2006 as a time to pick up the odd bargain.


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