Cusp of a sharemarket rally?

Stocks that have underperformed but are now being upgraded by analysts offer opportunities, says Deutsche.

Could the Australian sharemarket be on the cusp of another rally?

The analyst community isn’t enamoured with the local sharemarket right now, but that could be offering up some opportunities, according to Deutsche Bank.

Despite a pullback of up to 7.5 per cent in the benchmark S&P/ASX 200 share index this month, the proportion of S&P/ASX 100 companies that currently have “buy” ratings remains near a record low, although the number of companies in that group has risen slightly in recent months.

Deutsche Bank equity strategist Tim Baker says investors should ideally be looking at stocks that have underperformed the broader market and are now enjoying some upgrades from analysts.

His four-quadrant scatter plot of S&P/ASX 100 companies has AGL Energy in the best possible position. AGL surged almost 6 per cent on Wednesday on a share buyback announcement and higher dividend payout ratio guidance. Aurizon, Qube Logistics, Iluka, Spark Infrastructure, Sydney Airport, BlueScope Steel, James Hardie, GPT, Incitec Pivot and Sydney Airport are in a similar position.

But Deutsche Bank’s Baker is understandably wary of companies that have outperformed the market and are now copping downgrades. Companies in that group include Fletcher Building, Harvey Norma, Flight Centre and Challenger. Still, he thinks the building cycle will extend further. He likes Stockland since it’s underperformed and is out of favour with analysts.

Companies that have outperformed and been upgraded by analysts might also warrant some caution. Healthcare names including Cochlear, Healthscope and Ramsay are at risk of becoming crowded long trades according to Mr Baker. He’s also worried about UK exposed stocks in that category, such as Computershare, Iress, Treasury Wine and Ansell.

Looking at the overall market, while there’s little correlation between the number of buy ratings and index movements, the market does tend do to better when analysts are upgrading, which is why so much attention is paid to the ratio of upgrades to downgrades, the so-called revision ratio. Thus with the proportion of buy ratings bouncing off a record low, it’s tempting to think the market can rise.

The rally in shares which pushed the S&P/ASX 200 up to a 12-month high near 5600 points in early August followed an intensification of yield-seeking behaviour as interest rates hit record lows due to central bank policies. Combined with generally disappointing earnings guidance from the August reporting season, the sharemarket rally saw the forward price-to-earnings valuation touch a decade high around 16.8 times, triggering a round of downgrades from analysts.

But the downgrades in August masked an improving earnings per share trend due to stronger commodity prices and cost cutting in the resources sector. Forward EPS estimates are up about 8 per cent since March and the question is whether earnings will continue to improve, validating the PE ratio. At about 16 times, it’s still almost 18 per cent above the ten-year average.

The world could still face a weaker growth impulse stemming from uncertainty caused by the Brexit vote, even if a weaker pound is offsetting such negative effects in the UK. But Australian resources companies have great leverage to firmer commodity prices now China is moving toward greater fiscal stimulation and its economy continues to show signs of stabilising after last year’s slump. That could help support the Australian earnings outlook in the face of any European drag.

Of course some investors will fret about the potential for a Brexit-style sell-off in global risk assets including equities ahead of the US Presidential election, but perhaps the local market will be closer to 5600 than 5400 by November 8, particularly if CPI data next month point to another RBA rate cut.