A New Year a New Market!

Today I want to talk about what we can expect from the market over the next 12 months. Those regular readers would be well aware that in the short term we expect some market weakness. This will provide a buying opportunity, but what to buy? Below I'll discuss a number of issues which I believe will affect the market over the next 12 months and give you a good idea where to invest.

Priced to Perfection.

After such a strong run, market and individual stock valuations are looking full. Longer-term interest rates may be trending up and there are early signs of a repricing of financial risk. Therefore, the upcoming reporting season will be critical as the market seeks to 'fill' full valuations with 'corroborating' earnings growth.

Broad valuation metrics suggest the Australian market is fully valued. The 12-month forward price earnings is 15.8 which is above the long-run average of 14.4. Ex Resources, the Industrials PE is a more challenging 18.6x. Our market continues to trade at a slight discount to the US, but closer to parity than it has been for some time.

The market's trailing dividend yield is about 3.4% while, following recent increase in bond yields, the earnings/bond yield is broadly at parity. While this appears less attractive for equities than previously, we do not believe that it alone makes for a compelling case for switching cash out of equities and into bonds.

All eyes will be on how well companies have performed over the past six months and as we move into the next reporting period I expect that share price of any company which does not meet or exceed market expectations will take a hit. The below table indicates how companies have performed in the past.

Cash is King

The current level of cash seeking assets in the market is unprecedented, and in our view is likely to remain the single most important thematic in the near term. We believe there are four sources of cash currently seeking assets: growing superannuation fund flows, private equity, corporate balance sheets remain cashed up and under geared, and the Commonwealth's Future Fund is approaching investment phase.

Outlined in the table below are our estimates in terms of potential net fund flows into the equity market for FY08. These funds should provide good support for our market over the next 12 months.


As indicated in the table above, we believe up to A$100bn in new cash could flow into the Aussie equity market over the next 12 months. The level of activity in 2006 was about A$62bn (including T3), while 1Q07 volume was A$10bn

Revised Sector and Stock Recommendations

Key sector recommendation are as follows:

Alcohol & Tobacco. Underweight (previously Neutral). Better options available to position the portfolio for the expected stronger global growth

Consumer Staples. Neutral (previously Overweight). Our previous recommendation was defensively oriented. We now use the former Overweight position as a funding source for increased exposure for sectors more directly exposed to stronger growth.

Energy. Overweight (previously Neutral). Repositioning for stronger global growth

Telcos. Neutral (previously Overweight). Better options available to position the portfolio for the expected stronger global growth. 

Transport. Neutral (previously Underweight). We had been underweight Transport due to our reservations regarding Australian economic growth. As discussed above, we have increased our Australian GDP forecasts and therefore have upgraded our sector recommendation to Neutral.

In summary, our sector over/underweight recommendations are as follows:

Underweight sectors

Alcohol & Tobacco. See comments above.
Basics. As discussed above, we believe it is still too early to move into cyclicals.
Gaming. We continue to believe the sector is fully priced at current levels.
Infrastructure. We remain underweight this sector due to concerns re rising interest rates, potentially on the back of sustained economic growth.

Overweight sectors

Capital Goods. Expected ongoing strength in infrastructure and engineering spending.
Energy. See comments above
Mining. Ongoing Chinese and global economic growth, and the supply response remains constrained, particularly in the bulk commodities.
Financials. Especially the wealth management stocks.

If you would like to know more about how this effects you portfolio please contact your adviser on 07 4771 4577.