Why Aussie Shares Have More To Go.

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Why Aussie Shares Have More To Go
September 2007 - Australasian Investment Review – (AIR

After the sharpest correction in over four years into August, Australian shares have recovered all of their losses and made new highs.
According to the chief strategist for AMP Global Investors, Dr Shane Oliver is the big question is: where to from here?
He wrote this week in the wake of the markets hitting new highs on successive days (with a lot of help from BHP Billiton, it must be said)

As far as corrections go the 14.8% fall in Australian shares from their July high to their mid-August low on the back of the sub-prime crisis in the US was pretty normal in terms of magnitude. What has been surprising though has been the speed of the rebound.

Through the cyclical bull market in shares in the second half of the 1990s, 10% to 20% corrections occurred every year but it took between 3 to 5 months for the market to recover to a new high. This time around it has taken less than six weeks. Since their low in mid-August, Australian shares have risen 18% or over 1000 points. Over the same period global shares are up, but only by 9% on average.

While all markets have benefited from the Fed’s interest rate cut there are several reasons for the relatively stronger rebound in Australian shares.

These include the solid profit reporting season last month, the realisation Australian financial institutions have little subprime debt, the perception that Australia is protected from a US slump to some degree by its exposure to China and Asia and solid fund inflows partly reflecting the investment of pre-June 30 superannuation inflows.

After the 1998 credit crunch US shares recovered quickly as the US was at the centre of the then bull market in shares, whereas Asian shares were relative laggards and so was Australia given its Asian exposure. Now it’s the other way around.

The US is at the centre of the problem, whereas Asia and emerging markets are doing very well and at the forefront of the bull market. Consequently, Asian shares have rebounded far quicker than US shares (and global share indices that it dominates) from the recent correction & as Australia is a key beneficiary it has too.

Consistent with Australia’s Asian exposure, resources shares have led the way out of the latest correction in contrast to industrials that led out of last year’s correction.

The cyclical bull market has further to go Cyclical bull markets go through three phases and the current bull market that began in 2003 is no exception:

Stage 1: A recovery phase from excessive pessimism - which characterised the initial share rally in 2003; An earnings driven phase where strong earnings growth drives share prices higher – this has essentially been the case since late 2003 into this year; and

Stage 3: An exuberance driven phase where share prices rise faster than earnings - as investors become increasingly optimistic pushing share valuations to extremes.

Stage three is usually the most volatile as more investors become exposed and shares start to lose some of their earnings support. It can last for years as was the case in the late 1990s in the US. Our assessment remains that we have now entered stage three, but it is still early days and we are a long way from reaching the extremes that normally characterise bull market tops.

After spending years tracking below our fair value estimate, the Australian share market is now in the middle of its fair value range. But while the market may no longer be cheap it is not expensive either. This is because shares have simply been rising with earnings. A similar message is provided by the forward PE. It is now around 15.4 which is close to its ten year average of 15.3, but below its 1999 high of 18.3 times.

The cyclical back drop remains favourable. Our assessment is that the Fed will be successful in engineering a classic mid-cycle slowdown in the US economy and, by implication, global growth. While this is not without risk it will take pressure off global inflation and interest rates. So the US downturn is likely to be a classic “pause that refreshes” allowing the global economic expansion to continue and low inflation to remain.

While profit growth will slow it will still be positive and more importantly, interest rates will move lower ensuring liquidity conditions for equity markets will be favourable. Lower US interest rates are normally associated with rising PEs. Investors are still not euphoric.
One of the classic signs that we still haven’t reached the end of the cyclical bull market is that we haven’t seen the investor euphoria that normally accompanies bubbles.

The proportion of Australians nominating shares as the wisest place for savings is running around 15% which is well below peak 2000 levels when nearly 35% nominated shares as the wisest place for savings. This suggests there is still a degree of healthy scepticism about shares.

Stage three in a cyclical bull market normally sees slowing profit growth, rising PEs and rising volatility, which we are now seeing!

While the Australian share market has already moved from being cheap to around fair value, it is likely to be pushed towards the top end of its fair value range as shares start to rise faster than profits.

While cheap debt has dried up for now, there is a high likelihood that easier global monetary policy, investment flows from trade surplus countries, super fund inflows and Future Fund inflows at a time of relatively constrained capital raisings will push Australian share prices up beyond fundamentally justified levels, i.e. up towards 7000 for the ASX200 on current fundamentals.

Just as shares spent several years below fair value they may now spend several years above it.

Stage three of cyclical bull market is also characterised by declining breadth as a smaller group of regions, sectors or shares participate (like tech stocks in the late 90s).

Likely candidates for a speculative surge include Asian shares – which are benefiting from a region which is booming and in good shape – and resources shares on the back of the China/BRICs boom. The latter will benefit Australia.

While we have now entered a more risky PE multiple expansion driven phase in the share market, so far valuations are reasonable, the cyclical backdrop remains positive and investor exuberance is not extreme.

So while shares are a bit overbought on a short term basis and bad news on the US economy could trigger a short term setback, the broad trend in shares is likely to remain up. The bull market has further to go.

Copyright Australasian Investment Review.
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