Equities on the rise, but it could be a bumpy ride

Illustration: Karl Hilzinger.AFTER five years in the wilderness – and a few false starts – the equities market could finally be on the road to recovery, with the reporting season expected to give it a further gee-up, assuming no unforeseen setbacks.

It is a message that is being promoted by investment banks as they start to pump out pre-reporting season notes. Brokerage Citigroup wrote on Tuesday: ”If we’re right and the reporting season is reasonable, it should give further impetus to the market, though it has run hard lately, and partly on some encouraging signs about the results. But we still expect the market to go higher through the year, with our S&P/ASX 200 target of 5200 for end 2013, as moderate earnings growth returns in full year 2014.”

A return to equities is being driven by falling interest rates rather than any improvement in the economies of Europe or the US, or Australia for that matter.

In Australia, one year term deposits are yielding around 4.2 per cent pre-tax, which is low in comparison to stocks such as Telstra and the banks. To put it into perspective, Telstra is yielding 6 per cent fully franked even after its shares jumped more than 80 per cent in the past two years. NAB is trading on a fully franked yield of 7 per cent despite its shares rising 20 per cent in the past few months.

If the Reserve Bank cuts official interest rates next week or next month, term deposits will fall further and the switch to equities will gather momentum. Macquarie Equities recently observed that Australians were taking the view that ”lower interest rates via lower mortgages rates will be the catalyst that shakes Australian households out of their GFC-induced malaise and finally drive the upswing in earnings per share growth that has been so absent this market (ex-resources) over the last three years”.

Since November the ASX 200 has shot to its highest level in 21 months on fatter volumes. In the US the market is just shy of hitting an all-time high largely because investors haven’t had the choice to put their money in the bank because interest rates are so low.

It is a similar story in the UK with billions of pounds pouring into equities in the past three months, resulting in the FTSE rising 6 per cent this year.

Back home the rally continued after the release of NAB’s latest business survey, which showed confidence rose in December. The flurry of activity was undoubtedly caused by an element of panic buying from investors wanting to get in on what some are calling the beginning of a bull market.

For this reason, this profit season will be more important than most as it will provide what Goldman Sachs refers to as a ”reality check as to whether recent market optimism is suitably placed” and the extent to which prices have run ahead of fundamentals.

After a number of rallies in recent years, which couldn’t be sustained, investors have become wary of equities, particularly after a string of shock profit downgrades along with falling commodity prices and rising costs.

The truth is high yields have brought investors back to the market rather than great strategy or great management. If anything, analysts don’t see much in the way of earnings growth in 2013. According to Goldman Sachs: ”We see little reason to expect much positive earnings surprise through the reporting season, with domestic economic momentum remaining poor, and perhaps even weaker than the data suggests given the recent hot and dry weather conditions. If anything, we expect modest downside risk to earnings forecasts consistent with the trends seen through the October-November AGM season.”

Macquarie Equities believes the profit season presents ”real risk” to those share prices that have risen in anticipation of an improving growth outlook, but to date none is evident.

Most investment banks identify a handful of companies that will surprise on the upside, and others that will disappoint. Citigroup identifies 10 stocks that it believes will surprise this reporting season. On the upside, it believes IAG, Myer, Santos and McMillan Shakespeare will do better than consensus. Those that face downside risk include Leighton Holdings, Cochlear, as it faces the roll-off of foreign exchange hedge gains, David Jones, Woodside Petroleum and Origin Energy.

Whatever the case, the most likely trend is companies relying on cost cutting and productivity gains to bolster margins and lift underlying growth.

In the past few months a list of companies have flagged cost cutting as a way to improve profits. Rio Tinto, Boral, QBE, Bluescope Steel, Fortescue Metals and numerous others have joined the chorus of cost cutters.

But at the end of the day punting on the direction of the stockmarket is fraught with risk. With a federal election looming and a mixed bag of economic data pouring out both locally and globally, there will no doubt continue to be some hiccups along the way.

The original release of this article first appeared on the website of Hangzhou Night Net.

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