Investors must be vigilant with nosebleed valuations

Valuations are high and risks are everywhere but this is not a bubble.

Valuations are high and risks are everywhere but this is not a bubble. Picture: Supplied

Now that the reporting season is effectively over, it’s telling that the local market is near all-time highs. More than 85 per cent of companies have reported and earnings across the market came in slightly above analyst expectations.

Earnings growth for the 2021 financial year will end up printing somewhere between 30 and 40 per cent, which is both extraordinary and unrepeatable, at least in the near term. (There are, of course, a few laggards to come in the days ahead).

Indeed, the lockdowns in Victoria, the ACT and NSW have caused CEOs to pull their collective heads in with respect to outlook statements. And for many companies, the first month or two of the new financial year has seen year-on-year sales decline by double digits.

The lockdowns are really having a detrimental effect.

For discretionary retailers at least, the “economics of enough” are definitely resulting in a higher frequency of promotions, meaning not only are sales down but so are the margins being made on the products sold.

The “economics of enough” is the term I use for the period of retail digestion that occurs after a bout of retailing exuberance. NSW, Victorian and ACT locals simply purchased enough sofas, T-shirts, athleisure gear and printers during last year’s lockdowns. They don’t need, or even want, more stuff this year.

For the analyst community the effect is a scaling-back of earnings growth expectations for the 2022 and 2023 years.

Of course, weakening economic conditions have a material impact on the prospects for our banks.

When we entered the first Covid lockdown, CBA’s share price was almost half what it is today. Against expectations of a steepening yield curve and a near certainty that the worst – in terms of net interest margins and credit growth – was behind it, we loaded up.

Today, the outlook for the banks is less clear. The resumption of the lower-for-longer rate outlook means support for share prices but it also translates to pressure on margins. Meanwhile, stalling economic momentum puts pressure on credit growth hopes.

Over in the US, more than 95 per cent of companies have reported their second quarter results and 87 per cent have exceeded expectations, a new record. Consensus estimates for year-on-year earnings were a 55 per cent jump. Earnings actually grew by 95 per cent!

Investors are optimistic about a post-pandemic outlook, with the vaccine rollout likely to accelerate after the government announced an indemnity scheme providing access to compensation if individuals suffer adverse effects from vaccines while also protecting health professionals and employers from claims if they vaccinate workers in-house.

But clouds might be brewing particularly with respect to Covid. We are now coming to appreciate that vaccine efficacy declines through time, and potentially faster with the mRNA vaccines.

In global markets analysts are noting an increasing number of people in hospital (some 60 per cent of cases in Israel) are double vaccinated. It’s fuelling the arguments of the anti-vaxxers but this appears to be a function of the sample set.

When there is a very high level of vaccination coverage across the population, as there is in Britain and Israel, the chances of a higher number of hospitalised cases being fully vaccinated are higher.

Importantly, as the British experience demonstrates, with a higher vaccination coverage, total hospital admissions are only a third of those experts would expect to see if a lower share of the population were fully vaccinated. The vaccines also seem to be maintaining efficacy against severe illness.

Despite all this, there is enough concern over waning immunity levels that most well vaccinated countries are now planning booster shot campaigns to bolster protection at least for the higher risk cohorts.

Meanwhile, as the Delta variant throws awry the best laid plans, there’s a new Covid variant. First discovered in May in South Africa, the so-called C. 1.2 variant has subsequently been uncovered elsewhere in Africa, as well as in Oceania, Asia and Europe.

While the World Health Organisation has not listed it as a variant of interest or concern, C. 1.2 has attracted scientists because it harbours mutations similar to those seen in the Delta variant, and more.

With our government’s plan to offer vaccine boosters only after everyone has received their first two shots, we are guaranteed to have a large proportion of the population – those who were vaccinated early – with less protection, just as the business lobbyists succeed in opening up our country to international travel.

Stockmarkets crash when something unexpected and adverse hits sentiment.

A variant of the virus that evades the vaccines would send the world back to square one. We aren’t there yet, but investors need to be vigilant because the US market is expensive with 12-month forward price-to-earnings multiple high at 22 times. US-listed companies will need to keep delivering rapid earnings growth to support the market. Of course, pockets of bubble-like valuations will persist but that doesn’t imply the entire market is a bubble.

Nevertheless, the combination of nosebleed valuations in some corners of the market, along with concerns about Delta (and 25 per cent of the global population being vaccinated, providing ample opportunity for a vaccine-evading strain to evolve) suggests a post reporting season “opportunity” is possible.

I am an optimist, and in the absence of a “black swan” event, the path to reopening is a definite positive.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management.