Shares likely to remain out of favour

The valuation of Australian equities has become technically attractive, but there is little reason for investors to buy into this market.

The share market is trading 17% off its level of one year ago, and a strong dose of negative sentiment should drive shares further south before the end of the financial year next week.

The domestic market is a follower. Rarely do local shares set a stand-alone trend, instead it tracks the trading pattern of the larger European markets and of course, Wall Street.

Despite that, the performance of the Australian market has been worse than its international peers, with the Dow Jones down 11% and the FTSE in London off 14%.

The reason is that the Australian market, thanks to the resources boom, had more pent-up momentum in shareprice valuations and earnings growth than the overseas bourses.

After a bull market, which started climbing in March 2003, the run-up in valuations and the market's average return of 25% annually defied expectations.

As the S&P/ASX200 recovered towards 6400 after last July's credit crunch inflicted dip, experts thought something had to give. By November 1, when the market reached its peak of 6828 points, the fears of a bust became greater.

Then along came the Centro woes in December and the punishment was unleashed for any Australian stock that was highly leveraged and had complicated financial structures investors struggled to understand.

Any hint of debt troubles sparked a shareprice showdown run; think Allco, then MFS (now Octaviar) and ABC Learning Centres. These stocks lead the list of the market's worst performers.

In the six months of the current calendar year, the ASX200's low was 5086.1 on March 18 - a fall of more than 1700 points from its peak and evidence the market was firmly mired in bear territory.

There has been a slight bounce since then, but most analysts agree there is little positive sentiment at the moment.

The rush of selling in the lead-up to the end of the financial year has not been met with any support by buyers.

The dampened sentiment has been exacerbated by superannuation funds facing the first negative return for years and fund managers clearing the books of losses to offset the profit gains that may have been accrued from the powerful resources sector.

Having watched the fall, and only tiny rebound from the March trough, there is little incentive for many investors to be participating in this market.



It is significant that in its portfolio recommendations, Deutsche Bank's largest "overweight'' position is in cash.

And why not? The interest rates on some cash management accounts with the majors defies belief. An account with BankWest is now offering 8.7% for a one-year fixed term deposit of between $5000 and $2 million.

Across the road, NAB, is offering 8%-8.2% "blackboard'' specials in a bid to increase its retail deposit base.

The cost of wholesale funds for the major banks to finance their mortgage books has retreated slightly from the peak, when the rate on 90-day bank bills hit 8.11%.

However, the spike has made the majors return the emphasis on working their retail deposits and the rates on offer to investors are better than most returns available on the market at the moment.

NAB and ANZ have attractive dividend yields at about 7%, but there are risks in holding the financials. The share prices of the major banks are down 31% since November last year.

A by-product of the market's fall since November has been the marked reduction in price-earnings ratios for stocks, especially the industrials.

An analysis by UBS equity strategist David Cassidy showed the forward PE for industrials has slipped from 18 times to 12 times, but that's still not enough to entice investors to buy in.

The pull back in industrials on a six-month rolling basis, he said, was the sharpest on the Australian market since the 1987 stockmarket crash.

"Sentiment is poor at the moment and we believe the current macro environment of faltering growth and elevated inflation could force equities lower in the short-term,'' Mr Cassidy said.

In light of the valuation reductions, there is now some concern that the profit and earnings expectations for the year ahead are too buoyant.

The consensus call for earnings per share growth in 2009 is 22%, of which Deutsche Bank's Tony Brennan believes most will come for the bullish resource sectors.

However, Mr Brennan said that expectation for profit growth has already been priced in to current equity valuations.

"Our concern is that earnings fall short and given the pressures on companies, this ultimately holds the market back,'' he said.

The market sentiment is also being driven by the confusion surrounding the state of the Australian economy and the prospects for global economic growth.

Interest rates in Australia should have hit a peak with the official cash rate at 7.25%, as all of the evidence emerging reveals a sustained reduction in demand growth and activity.

The Reserve Bank should take comfort in its engineered slowdown, but some market economists believe the moderation is either too fast or too slow to appease the central bank.

If the moderation is too slow, then there is a real risk the RBA would raise interest rates once more. I that happened, it would be negative for equities because the chance of a hard landing for the economy would increase, and a rate rise would further reduce the demand to buy equities.

Either way, a cooling of demand growth will damage the fortunes of companies dependent on consumer's financial health and ability to spend.

In the US, it appears that the fed funds rate will be kept at 2% on Thursday morning, Australian time, when the Fed's meeting concludes in Washington.

The move to stop the cutting cycle should give markets confidence the worst of the credit crunch has passed, but again it highlights the risk of inflation on world economic prospects.

The inflation threat is firmly on the investment radar at the moment.

Analysis by Goldman Sachs JB Were says that during times of low inflation and rising inflation equities usually outperform bonds and cash asset classes, but in a high inflationary environment the fixed incomes products generated stronger return.

In the Australian market, if inflation were to edge higher, the investment bank has identified ASX, Aristocrat Leisure, Iress and Cochlear as being well positioned to ride out the turbulence.

At the other end of the scale, the bank predicts media stocks such as Seven, Ten but also Coca-Cola Amatil will be hit.

"We continue to believe the market will be driven in the near term by increasing concerns around earnings risks offset by what appears to be attractive valuations,'' GSJBW's strategist Chris Pidcock said.

"Near term we expect sentiment around the earnings risk will win and therefore remain cautious given the discrepancy between top down and bottom up earnings growth forecasts for 2009.''

The sentiment towards equities was boosted somewhat in the US with the rescue of stricken investment bank Bear Stearns by the Fed and rival JPMorgan.

In Australia, with the present fears over the earnings outlook, concerns about debt and uncertainty as to the direction of the economy, there is little to spark a sudden burst of enthusiasm.