04 Mar 2013

The chicken or the egg conundrum

James Dunn | 27 February 2013

Like the chicken-or-the-egg conundrum, it is always an interesting question as to whether increased confidence in the stock market causes it to rise, or whether a rising market makes investors more confident.

Australian shares have not been the place to be over the past five years, actually losing money for investors. But in June 2012, the share market’s S&P/All Ordinaries Index began to move, and has gained 26 per cent since then, surging through the psychologically important 5,000-point level on both the S&P/All Ordinaries Index and the S&P/ASX 200.

At the same time, the market’s forward (prospective) price/earnings (P/E) ratio bounced sharply off ten times earnings, and has risen to about 15.5 times earnings.

The rise has sparked investor interest. Or did a pick-up in investor interest drive the rise?

Certainly, indicators of bullish sentiment are flashing ‘green,’ here and overseas, as money pours back into the market, in what European Central Bank (ECB) President Mario Draghi calls “positive contagion.” The massive amount of central bank liquidity support thrown at the markets, plus the new-year political deal in the United States to avoid the so-called fiscal cliff and improving economic conditions in China, have helped to push stock markets higher. Simultaneously, difficulty in extracting any return from over-bought bonds and minuscule interest rates, have driven investors into the so-called “great rotation” out of bonds, and back into shares.

Here in Australia, the Reserve Bank of Australia has cut the official interest rate to 3 per cent, holding just above a record low. Investors are starting to respond to the lightening of interest-rate pressure, with the Westpac/Melbourne Institute Index of Consumer Sentiment rising by 7.7 per cent in February, from 100.6 in January to 108.3 in February, the biggest monthly gain since September 2011 and the strongest reading on the index since December 2010.

The increased confidence is definitely being felt on the stock market.

Many retail investors sought safety from the turmoil fatigue they have suffered since the GFC in term deposits, where they were rewarded through a price war as banks competed for retail deposit money to replace some of the wholesale funding avenues that had temporarily closed. In 2008, term deposit rates paid at least 6.5 per cent return, risk-free. Rates like that hardly encouraged investment in shares – which had demonstrated that they were prone to alarming falls.

Five years down the track, term deposits are more like 4.5 per cent, almost a one-third haircut on income.

That in turn has led income-oriented investors back to the sharemarket, where they can replace those 2008 term-deposit income levels in shares, with the added benefit of the tax-effectiveness of franked dividends, and the bonus of capital gain.

The major banks are offering nominal yields of 5.4 per cent-6.7 per cent, which translates to 7.7 per cent-9.6 per cent with franking (even higher if the shares enjoy super-fund tax rates of 15 per cent in accumulation mode and nil in pension mode.) Telstra yields about 6.1 per cent nominal, and 8.6 per cent with franking (and into double figures for a super fund.)

For retail investors, such yields are hard to go past. Indeed, it is no surprise that Commonwealth Bank, Westpac, Telstra, ANZ Banking Group and CSL contributed more than half the sharemarket’s gain in 2012. The search for yield has been a major driver of the market rise.

P/E expansion – where the P/E ratio rises in expectation of an improved earnings performance down the track – has been the other major driver of the sharemarket’s rise. The market has “re-rated” the Australian sharemarket by more than 50 per cent on P/E grounds: now the better earnings flow must come through, or prices will come under pressure.

Overall volumes on the Australian Securities Exchange (ASX) have been struggling for some time. The average daily number of ASX sharemarket trades in the December 2012 half-year was 7 per cent lower than it was in the June 2012 half, however, and 12 per cent lower than in the December 2011 half.

The average daily value of trades in the latest half was $3.77 billion, down from $4.37 billion in the June half. In contrast, average trading values ranged between $6 billion and $7 billion a day at the height of the sharemarket boom in 2007, and $5 billion and $6 billion days were common in 2010 and 2011.

In 2012, stock market turnover sank 18.5 per cent to $2.2 trillion, the lowest since 2005.

In January this year, as shares surged, the average daily trade value slipped further, to $3.6 billion. But in the week of 18-22 February, market trading volume recorded its strongest growth in almost a year, with the average daily value of trading returning to $5 billion-$6 billion, according to data from the IRESS trading platform.

In the retail investor market, some interesting figures from CommSec point to a definite resurgence of investor interest.

CommSec holds 50 per cent share of the Australian online broking market, and has 1.8 million customers. The broker reports that trading volume in January was up 35 per cent on the same time in 2012, and the average number of daily trades had risen from about 50,000-60,000 a day three months ago, to about 85,000 today.

CommSec says clients are opening the first new margin lending account since 2010, and existing clients are registering shares as collateral in readiness for borrowing again to buy shares.

Clearly, retail investors are getting interested in shares again. But from here, it is critical that earnings follow through to justify the last eight months of P/E expansion – or the market will give up a big chunk of its gains.

James Dunn is a financial journalist and media consultant. The views expressed are those of James Dunn, not necessarily those of Vanguard.


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