Posted by: Clime Asset Management
Readers are constantly bombarded with predictions for the “end of year target” for the Australian sharemarket. In the main, these predictions are made by commission agents seeking to generate buying activity. Their modus operandi is to scare investors into believing that they will miss out on the market boom that lies ahead, just beyond the horizon.
However, predicting that the price (measured by the index) of equity markets will rise over time is actually not a bold prediction; that is what markets have always done over long periods. However, a focus on a short period, like the next nine months, is pure speculation, particularly so if it is not based on some assessment of value. A couple of points need to be understood when forecasting the direction of equity markets in Australia.
Firstly, over time, the Australian equity market’s value has and will continue to steadily rise. This is a function of solid recurring economic growth generated from population growth and the flow of equity capital into Australian companies. This equity capital is retained by companies from profits and/or raised via new issues. Value is derived as a multiple of equity; this is a function of the return on that equity. With more equity and a growing economy, profits will rise over time. The question that most commentators ignore is the rate of return on capital; unfortunately, for the last five years, Australian companies have generated poor returns using this metric. That is why the market today is at the level it was in April 2006.
Secondly, there are large macroeconomic environmental issues that drive the direction of markets. The two biggest macro issues for Australia today are the direction in the prices of our major export commodities and the trading value of our currency. Over the first quarter of this year, the Australian equity market has largely ignored a sharp decline in the price of iron ore and a lift in the exchange rate. These factors are negative for the major mining companies that are so crucial for generating earnings and capital investment.
It follows that the most likely market outcomes are as follows: continuing weakness in commodity prices, continuing increases in the unemployment rate, and a steady decline in capital investment activity.
It is remarkable that many forecasters expect the Australian equity market to lift towards 5800 or 6000 by year end. They predict an economy whose growth is checked, but maintain their view that these issues do not affect the short term trajectory of the market. In doing so, they exhibit a “buy-side” bias that has been stoked by a long period of massively supportive monetary policy.
Our point is simple: market predictions made by commission agents are inherently flawed and will usually be vastly optimistic. It is far better to base a prediction on fundamental valuations which properly reflect the economic environment.
For the record, our view is that the Australian equity market is very unlikely to lift above 5800 by year end. However, should the Australian dollar suffer a sharp devaluation, independent of a decline in commodity export prices, then our market could quickly rise. A currency level of US$0.75 cents would see our market lift, but that could be a precursor to major inflation issues and sharply higher interest rates in 2015. The market, in such circumstances, would be in dangerous territory.
In contrast, should the currency revalue back to parity without a substantial lift in export prices, then our market would sharply retreat below 5,000 points. A higher $A would be bad news for Australian corporate profits, with the most dynamic of Australian companies being most affected.
If the above is confusing, then welcome to the real world. There is nothing easy about investing, and the current economic climate is both difficult to predict and subject to constant change. Those who blandly predict a rise in market prices, without stating the context for those forecasts, or including their assumptions for the currency, commodity prices, interest rates, and so on, are not actually trying to help you – rather they are either trying to scare you or sell to you.
Please note that the above does not reflect Elixir Private Wealth’s view and we have posted this article in the interest of sharing the divergence of thought across the industry and for educational purposes.