So far in 2016 the share market has done a remarkable job of swinging in a range predicted back in January. The benchmark ASX 200 reached it’s 2016 high last week, roughly at the peak of the predicted MoneyTalk Share Market Pendulum range.
So now the question is: will the share market break through to higher ground? Will the optimistic outliers prove correct?
There are a number of reasons this doesn’t seem likely…
1. The share market looks expensive relative to expected earnings
The ratio of share prices (across the market) compared with earning (expected by analysts) is called the “Forward Price/Earnings Ratio” or “forward PE”.
The PE ratio, and particularly forward PE, has long been one of the main “rule of thumb” measures of value used by market participants.
Right now, forward PE is high at just below 17 x compared with a long term average of around 14.5 x.
And as the graph shows, current levels are rarely exceeded for long.
2. Expected earnings are unlikely to surprise on the upside
Last year Analysts expected earnings to increase around 10% in 2016. Over the year expectations have been wound back to expecting a slight fall in earnings (-0.5%). This year, guess what? Analysts are expecting earnings to increase around 10% in 2017… despite the headwinds that continue to face Australia’s businesses.
As the graph shows, this overly optimistic outlook is typical in the half decade since the GFC.
In the face of the economy adjusting to the post mining investment boom, a slower China, a persistently strong currency, European weakness and lackluster U.S. growth, we suspect that earnings are unlikely to surprise on the upside, i.e. increase by more than 10%. In fact, if forward earnings turn out to be flat again in 2017, then the forward PE ration now is really closer to 19 x.
3. Iron ore prices aren’t expected to hold
As we demonstrated last month, the Australian sharemarket follows commodity prices disturbingly slavishly, and it’s likely that current strength in the iron ore price is part of the reason for where the market is now.
Commodity analysts however, point to short term (weather related) supply issues in China squeezing their domestic supply, and increasing Chinese iron ore port stockpiles. If they are right then iron ore prices will fall over coming months.
The Australian Government’s Department of Industry, Innovation and Science expects iron ore prices to fall from the current US$57 to around US$45 in 2017.
4. The U.S. share market is looking expensive too
The market was buoyed recently by stronger jobs data indicating economic resilience but not sufficient strength to encourage the Federal reserve to increase rates faster. The U.S. benchmark S&P 500 Index now sits near record levels despite the fact that analysts have dropped forward earnings estimates by an average of 5.3 percentage points between the beginning and end of each quarter since June 2015.
The S&P 500 is trading at 20.5x reported operating income, the highest multiple since 2009 and one of the highest levels since the dot-com bubble burst in 2000. And of course the U.S. is facing a Presidential election with all the uncertainty that implies, particularly with such an unusual and controversial Republican nominee.
5. China continues to slow
China’s overall imports have now declined for 21 straight months, while exports have fallen for 12 of 13 months, helping to drag economic growth to its slowest in a quarter of a century. In addition, monetary and fiscal stimulus in China, which has been propping up activity in the first half of year, is expected to begin winding down.
So it’s all doom and gloom then? No. If the market does pull back, then it will again provide buying opportunities for long term investors, because right now the value is difficult to see.
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