After a strong year, our rising sharemarket still has a long way to go

The earnings have still come through at our best stocks ... so here’s where to go hunting.

In Australia, the largest improvement in profit forecasts went to the energy and materials sectors, with financials a lagging third. Picture: NCA NewsWire/Joel Carrett

The ASX 200 Accumulation Index, which combines share price appreciation with dividends paid, closed off FY21 with a total return of 27.80 per cent.

It wasn’t the best performance ever, because back in 2007 the average dividend yield was higher, but 11 months of the 12 posted a positive return and every market veteran will assure us that this has never happened before.

In the past 28 years only 2007 managed to post a better result, delivering 28.66 per cent return.

As is standard practice, that formidable index performance was achieved amid continuous warnings over investor exuberance, excess liquidity and cheap money-inspired bubbles, and predictions the next Wile E. Coyote experience surely must be around the corner. Its only a matter of time!

I believe such criticism to be misguided. First, because markets look ahead and what they see is a sharp economic recovery, albeit not in a straight line, underpinned by supportive governments and central banks. Most important is that share prices have been supported by strong, continuous upgrades to market forecasts.

For investors there is at least one valuable lesson to be learned from the past 12 months: never bet against a market that is supported by continuous upgrades to profit (and dividend) forecasts.

And the trend in profit projections, both in Australia and elsewhere, has remained positive for 10 successive months.

What goes for individual shares equally applies to markets as a whole. Rising forecasts, even if they prove misguided further out, make present day share prices look cheaper. Thanks to the strength of this year‘s upgrades, the local market became less expensive even as the ASX 200 added 12.9 per cent since the start of the new calendar year.

In Australia, the largest improvement in profit forecasts went to the energy and materials sectors, with financials a lagging third. No surprise then that the ASX 20 has beaten all other indices in Australia over the past six months with a gain of 16.13 per cent ex-dividends. Equally noteworthy, on the assessment of Morgan Stanley, the Small Ordinaries is no longer trading at a discount to the ASX 100.

The direct result of all of the above combined is that the average price-earnings (PE) ratio for the ASX200 has fallen to 17.5x from 20x in January.

 The one sector that stands out in terms of valuations becoming cheaper are resources companies – energy, mining and mining services.

In this context, it remains remarkable that the price of iron ore has continued its upside surprise, but equally that most analysts remain convinced prices will reset at lower levels in the year(s) ahead.

Morgans issued a stern warning to investors recently: when prices start declining (not “if”), it’ll be the direction in the (new) trend that counts for more than the actual data. Morgan Stanley has suggested results and oversized dividends in August will mark the final hurrah for Australia’s iron ore miners.

Such forecasts might still be proven wrong, but they are preventing shares of the likes of BHP, Rio Tinto and Fortescue reaching full potential. FNArena’s consensus targets are currently $50.50, $135.50 and $22.35 respectively (only Fortescue is trading slightly higher) but if we were to take guidance from the bulls, Macquarie and Ord Minnett, these share prices could be 30 per cent higher next year.

The second observation is that few stocks are trading above consensus price targets with the August reporting season less than four weeks away.

Again, those prospects are not necessarily already reflected in today’s prices. As of Monday, July 5, a little over a quarter of the 434 ASX-listed stocks actively covered by the seven stockbrokers monitored daily by FNArena were trading above target. This means nearly three-quarters are still trading below target.

If you concentrate on the ASX200, only four stocks are trading above target: CBA, Wesfarmers, Fortescue and – only just – Transurban. I think the conclusion is obvious: unless analysts’ forecasts are completely out of whack with reality for the year(s) ahead, this is not a share market valued to the absolute maximum. Far from it.

Citi analysts, for one, don’t think analyst forecasts are unrealistic. If anything, their top-down analysis indicates EPS growth projections for FY22 in the US, and elsewhere, are still too low. It is their view that further upgrades should be forthcoming, predominantly for the cyclicals (miners, energy etc).

This then feeds into their expectations that the value trade – cyclicals and financials – will make a comeback in the second half because share prices usually respond positively to improving forecasts. Current forecasts for average EPS growth globally sit around 39 per cent for FY21, with anticipated growth of 10 per cent for FY22.

Looking forward to the upcoming August reporting season, Macquarie reminds investors the February 2021 reporting season generated the highest upgrades to analyst forecasts in two decades. While it appears that global cyclical momentum is now past its peak, Macquarie thinks there is still plenty of momentum left to turn August into another positive reporting season.

All of the above also suggests things are likely to become less straightforward into 2022. In simple terms: earnings forecasts won’t be rising forever. When they stop trending upwards, and possibly start declining, they might just be the trigger that pulls down a market that remains expensive on historical metrics.

Macquarie doesn’t necessarily disagree, but makes the timing dependent on the pace of slowing for the global economy over the months ahead.

It is not difficult to see why many institutional investors have adopted a more cautious stance recently, or why quality stocks are making a comeback. If the expectations expressed by Citi and Macquarie prove correct then risk will increasingly reveal itself in the year ahead.

A more cautious investor will probably use the August reporting season to start making preparations for riskier times ahead.

Rudi Filapek-Vandyck is editor of the research service FNArena.