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A bearish assessment on shares

15 Oct 2021 1 month(s) ago

One analyst says that the Australian market is overvalued on economic fundamentals. That is one way of assessing shares.

Share prices always need to be supported by underlying earnings. In theoretical terns, a share price is the estimate of the value of the future earnings of the companies. So if those earnings look like they will not be as good as expected in the future, then the share price, all else being equal (which it usually isn’t, of course), should weaken or disappoint.

Morningstar is arguing that the prospects for the Australian share market do not look as healthy as before.

“Our analysis of the Australian equity market indicates that investors should expect a total annual return from the equity market, including capital growth and income, of around 8% over the next five years. This is lower than the 10% achieved over the past five years, and significantly lower than the 28% return achieved over the past year.

“Our analysis is based on aggregating Morningstar's individual company earnings forecasts, which indicates a slowing in the earnings growth of the market to around 3% over then next five years from 5% over the past five.”

Morningstar also looks at what is called the earnings yield, which is one of the more useful metrics for analysing stocks. The earnings yield is the price-earnings ratio (P/E) upside down. The price earnings ratio is the earnings per share divided by the share price. Doing it upside down (the price of the share divided by the earnings per share) gives you a percentage figure that can be compared with interest rates.

With interest rates so low the earnings yield on shares still looks attractive, but as Morningstar points out, it looks like it will get weaker, making shares less attractive.

“We also estimate the earnings yield of the equity market has fallen to around 5% from 6% five years ago, as price/earnings, or P/E, ratios have expanded. Together, our 5% earnings yield estimate—implying a steady market P/E—and 3% earnings CAGR (Compound Annual Growth Rate) forecast form the basis of our 8% total return forecast.

Australia’s average price earnings ratio is only about half of that in the United States, at about 17 times. Morningstar says share prices could rise if PERs rise, but is sceptical about it.

“Although it's possible that equity market prices will be supported by further P/E ratio expansion, we consider this to be an unsustainable source of equity market returns. It's also possible the global economic recovery currently underway will lead to higher interest rates and reverse the P/E ratio expansion of recent years.”

Morningstar says its analysis suggests that the Australian stock market is on average around 10% overvalued:

But morningstar says undervalued shares can still be found. Here are the key takeaways:

“Australian mining companies have benefited significantly from strong iron ore prices in recent years. However, we don't believe recent iron ore prices are sustainable and we expect mining company earnings weakness to heavily weigh on Australian equity market earnings over the next five years. ?

"Low interest rates have boosted Australian equity market P/E ratios, but investors should be aware that this is a likely unsustainable source of returns and could reverse if interest rates increase. ?

“Recent merger and acquisition activity will change the composition of the main Australian indexes. The proposed ending of BHP's dual company structure is likely to have the biggest impact. BHP already comprises around 5% of the S&P/ASX 200 index but we estimate this will increase to around 9% if the dual company structure ends and the merger of BHP Petroleum with Woodside is approved.”

The ASX is heavily skewed towards materials and financial stocks (especially the banks). That means the iron ore and other commodity prices are crucial, plus the housing market, which is the core business for the banks and most of the other finance companies.

Meanwhile, Macquarie says that the next Annual General Meeting season will be important for indicating what the post-lockdown economy will look like:

“AGM season has become a mini-reporting season. At the last reporting season investors were largely willing to look through the negative impacts of the COVID lockdowns. But with progress on vaccinations, the economy will be opening up over the AGM season and to the extent possible investors will want to see how quickly activity is recovering. The other key issue is likely to be the impact of cost inflation and shortages, and whether companies are still able to pass on cost increases even as global growth slows.

“We collated our team’s views on whether they expect positive or negative surprise from each company’s AGM. Out 160 MRE covered stocks with AGMs, our team expect the event to be a positive catalyst for 44 stocks and negative for 19. This is an expected positive/negative surprise ratio of 1.4x. Our team expect roughly double the rate of positive to negative surprise from small caps (3.1x) compared to ASX 100 companies (1.4x).”



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