There is an old saying in the market – never mistake a bull market for genius. Remember, a rising tide lifts all boats. What that means is, keep a cool head in a hot market and don’t let your confidence get out of control.
I bring this up now as we are in the midst of a bull market for the first time in several years. The last true bull market finished with the advent of the GFC back in 2007. After the carnage of 2008, the market staged a recovery rally of about 30% in 2009, which ran out of steam at the end of that year and the market has been trading sideways since. Well at least until the end of the last financial year when it began to climb the wall of worry.
This is a term of endearment many professionals use to refer to the early stages of a bull market, when the market starts to move higher against predominantly negative sentiment. This is when the trend followers start to yell at the fundamental investors that the new trend has begun, while the purely fundamental investors sit on the sidelines waiting for evidence that the rally is justified, often too preoccupied with what is happening now, rather than focusing on what will be occurring in six to 12 months! There are plenty of those still saying this rally is unjustified.
Is the rally bull?
Since July 2012, the ASX 200 has rallied around 30%, establishing this run firmly as a true bull market. (Technically, a rally can be called a bull market after a 20% rise).
When bull markets begin, there is usually a shortage of fundamental evidence to support them. This is simply a function of the predictive nature of markets. They look into the future (rather than the historical or contemporary environment) and attempt to price that. Of course, markets are not always correct. As the cynics say, markets have accurately predicted 20 of the last 10 recessions.
Someone once asked me what is it that fuels a true, sustained bull market and my simple answer is earnings per share growth. Short term rallies may be fuelled by a normalisation of sentiment, a cut in interest rates (something we are seeing at extraordinary levels right now) or even a rebalancing of investor capital (something else we are seeing right now) but these catalysts can only sustain a rally for so long. It’s earnings growth that drives a true bull market. The ability of a market to rally without getting more expensive can only happen if the earnings per share of its constituents is rising at the same rate as the market.
The ASX 200’s long-term average PE is around 13 times. During a period of fear and caution this may fall to 10-11 times, prompting analysts to claim the market is cheap. As sentiment normalises (fear abates) and the market’s PE reverts to the mean of 13, a rally of say 20%-30% is possible, but it cannot be sustained without the support of earnings growth. It is unlikely that the market will move to a higher PE level without growth. As a bull market matures and becomes a boom, irrational exuberance drives PE expansion to ever more expensive levels, as markets move well ahead of growth.
The underlying support
We are enjoying (if you are not short) a strong equities rally, fuelled by historically low global interest rates, short covering and a shift by investors back towards equities from the favoured safe haven assets of the last few years. What comes next? We need to see a corresponding improvement in earnings growth from the companies in the market.
At this stage we are seeing limited evidence to support the new bull market; however the real test will be the results season in August 2013 and January 2014. The strong stock market is predicting a pickup in earnings growth and this will be needed to drive the market higher. In the event earnings disappoint, well the market probably will too.
Many of our stocks have experienced solid rallies already and we remain bullish on the outlook for stocks such as Clime Investment Management Limited (CIW) – a boutique fund manager in a strong growth phase, Cash Converters International (CCV) – retailer of second-hand goods and supplier of financial products, Automotive Holdings Group (AHE) – automotive dealership and logistics group and Hills Holdings (HIL) – an old Adelaide company in the process of a turnaround by former Telstra whiz kid Ted Pretty.
Regardless of the broader market’s actions, we at WAM continue to implement our investment process, which has provided solid investment performance over the long term (+18.3% pa since August 1999). I remain confident that the outlook for investors is bright, provided a sound and discipline approach is adopted.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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