Saturday, November 17, 2012

Will History Rhyme with '88 to '93?

While updating my spreadsheets today I was almost dumbstruck when looking at the long term BEV (birds eye view) chart of the All Ordinaries Index based on the data from Yahoo since 1984.

Here is the chart that grabbed my attention:

(Every 0 is a new high in the All Ords since 1984, every number below 0 is the percentage that the All Ords is on that date compared to the All Ord index number on the date of the last high.)

1987 was the most recent comparable fall in the All Ords to 2007/09.

After the 1987 fall, it took almost 5 years for the All Ords to hit a sustained new high after the bottom and just over 5 years to hit a new all time high. We are now 3.5 years after the 6 March 2009 bottom.

If 1987 to 1993 was to rhyme perfectly then we are 12 months from a new sustained high from the bottom and less than 18 months from a new all time high in the All Ords. If it rhymes earlier, then it might only be months, or of course it could be later, but our medium to long (3 to 7 years) term outlook is that it will happen.

How could this happen? A couple of ways:
1. Sustained lower interest rates could lead to a slow but constant increase in acceptable PE ratios as investors search for yields.
2. Lower interest rates could drag down the AUD leading to a resurgence in exporting and import competing industries including manufacturing, tourism and education, also maintaining/increasing full employment and leading to inflation.
3. A lower AUD would mean that net profits from overseas operations of Australian listed companies would increase in AUD terms (depending on hedging policies and positions).

While there are still large risks of a Euro breakdown (such as caused by a Greek exit), from an adverse impact of the US fiscal cliff (or the replacement Grand Bargain which would likely still be fiscally contractionary), or from a hiccup in the Chinese leadership succession or rebalancing/end to contraction, this is still well worth watching unless you see Australia as being in the same situation as Japan in 1990 to now.

Volatility is still highly likely as outlooks to European resolution ebb and flow and the fiscal cliff looms, but the medium (3yr) to long (7 to 10yr) term outlook for the stock market if history rhymes is excellent. What has happened to the US S&P 500 over the last 2 years in raw terms could be the template for Australia's next 2 years, provided unemployment is kept around current levels overall (although large sectoral changes are likely as the mining construction boom washes off).

You might also like to look at the last article about why the long term outlook for the All Ords is a buy.

All the usual caveats about not being investment advice etc apply.

The All Ords is a Long Term Buy

I believe the Australian All Ordinaries is a long term buy for AUD investors.

Most Australians ought have the great bulk of their assets in AUD denominated assets or hedge assets denominated in other currencies as most expenses are in AUD. This article is intended only to deal with the outlook for the All Ordinaries in AUD. See the Currency qualification at the bottom of the article.

My 16 main reasons are:
  1. Interest rates have begun falling and are regarded as likely to fall further as the mining and resource engineering construction boom begins to tail off.
  2. Long term stock market growth is at about its average relationship to GDP growth. Total stock market growth since 1960 has been about the same as total GDP growth. This is in spite of it being well below in mid 1974 and well above in 1987 and 2007.
  3. Growth in the market looking back over the last 5 years is in the lowest quintile of historical averages for 2, 3 and 5 year growth and below the 40th percentiles for 1 and 4 year growth.
  4. No growth in the market since the 4896 level of the All Ords of 6 March 2011 (2nd anniversary of the 2009 bottom) would mean that in 2015 there would have been 0% growth for each of  1, 2, 3, 4 and 5 years. For each of those periodicities that would represent growth in the 29th, 23rd, 23rd, 17th and 3rd percentiles (calculated historically recently), respectively. That is 4 out of 5 would be in the lowest quartile of growth rates. This very rarely happens.
  5. The AUD is unlikely to go much higher as it is more than 1 standard deviation above long term historical trends against most major currencies other than the JPY. A fall in the currency would make the higher employing Australian industries more competitive internationally and likely more profitable as there are few capacity constraints in those industries as they have been operating below capacity in many inputs because of increased international competition from now relative lower currency countries as well as lower wage countries. Overall corporate profitability would likely increase if the currency fell. Those that had foreign currerncy denominated net income would benefit even more.
  6. PE ratios do not reflect the fall in long term government bond rates from the 13 year average of 5.5% pa from Jan 1998 to Jan 2011 to about 3.1% pa this month. If these reductions in long term rates are sustained then, as in the US so far, yield chasing private investors could be expected to substantially re-rate the stock market higher over a period of say 2 years.
  7. Contraction of Australian federal fiscal policy is, while amplified by some timing differences in expenditure which will reverse in the following fiscal year, unlikely to be as contractionary in following years as it is in the current financial year.
  8. The federal and state governments are likely to stimulate housing construction for first home buyers to soak up employment lost as the mining and resource engineering construction boom washes off over the next few years. If the stimulus is limited to first home buyers of newly constructed dwellings, then the falls in interest rates are likely to have muted to negative effect on existing home prices as first home buyer switches from existing dwellings to new dwellings.
  9. As private balance sheets are repaired, increased cash flow from lower interest rates for mortgagors is likely to switch from debt repayment (particularly high interest rate credit cards) to spending, improving the fortunes of the discretionary retail and durables sectors.
  10. The standard Coppock indicator for Australia has turned upward from below zero, normally a positive sign for the stock market for a number of years (but not without falls/volatility and this indicator failed about 15% of the time.)
  11. The market doesn't look anything like a top. I have looked at the median growth at a market top compared to prior market tops over periods from 2 months to 5 years. Growths since the last market top in April 2011 in all the periodicities are substantially below the median growths between tops since the November 1991 top.
  12. Australian demographics are more favourable than many countries over the next 5 to 10 years, based on the current bi-partisan immigration numbers.
  13. Australia has no government debt problem unlike many other countries. We do however have a high ratio of private debt to GDP but this is manageable if people stay employed and interest rates do not rise much in proportionate terms.
  14. The growth in the Australian savings rate has taken place and is now stable. The "damage" from the large increase in the savings ratio is complete, although it could incerase further if there are external shocks from US fiscal cliff, Europe EURO zone exits or Chinese leadership eratics.
  15. While US unemployment including on a U6 basis remains high, total employment has been continuing to increase, growing the economy in total. US house prices may have bottomed. US mortgagor households in total continue to lower their repayments through refinancing to lower rates, giving the household sector more spending power than previously, or at least maintaining it in the face of shorter hours and lower wages for many. The US remains the biggest economy in the world (for now and probably for another 5 years.)
  16. Chinese fiscal consolidation seems complete for the present. While growth rates and increases in resource consumption might not approach former rates, and a rebalancing to consumption probably means less mineral and energy resource consumption, the end of falls will be positive, even if most people resent mere stability as they do in Australia at present.
Sure, there are significant risks from Europe (how long will Greece and Spain put up with 25% unemployment) and the US (the fiscal cliff would be very contractionary to GDP) but we have seen how stock markets in countries with dramatically lower interest rates have reacted to increased corporate profit margins and dramatically lower interest rates. Our own stock market has been more muted so far because the falling commodity prices have hit profitability of the large mining & resource sector, but the rest of the market has had a significant increase.

Tactical timing of further investment
With the US fiscal cliff likely to involve the Republican controlled House and Democrat controlled Senate testing each others' resolve in a fiercely partisan contest over the coming 2 to 4 or even more months, there are likely to be scares in the US markets which will reflect into Australia. There is also the possibility of a Greek exit from the EMZ or EUR and Spanish resistance to Spanish bank bail outs other than for Spanish depositors. There are likely to be better buying opportunities in the next few months but the prediction of the timing is impossible and the markets could become quite volatile. It will be very hard to buy at the bottom as things could seem as if they are going to hell in a handbasket. Perhaps the best strategy is to dollar cost average purchase a proportion of your available investment funds over the next 6 months, although the risk in waiting a month or even 2 before starting purchases is in my view reasonably low.

Currency qualification
If as might be the case the AUD falls relative to other major trading partners/countries then the growth in the stock market might be offset by falls in the currency on the basis of comparisons with other countries stock markets when converted at market exchange rates. The AUD could well fall so that the net value of the stock market in say USD terms is no better than today.