Be ready to strike when the price is right

Chief Investment Officer and founder of Aitken Investment Management
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In terms of tactical (i.e. short-term) equity strategy, I remain cautious on Australian equities, feeling a May through July pullback to the 5100 to 5200 range is likely and, potentially, already underway.

We have tried to position investors for this pullback via warning on high growth momentum names, downgrading the bank sector to hold, and downgrading many individual stock recommendations from buy to hold.

I feel the falling iron ore price, weak post budget consumer confidence, domestic data fade, earnings downgrades, falling bond yields and the heavyweight bank sector being ex-dividend will all be factors driving the pullback.

Valuation correction

Around 5500 points I was genuinely struggling to find value. That meant I was struggling to find stocks that I would be prepared to physically buy at the current price. In my career whenever that has happened it has been followed by a pullback, which produced clear and present value again.

That is all I think is happening or likely to happen in Australian equities: a short-term valuation correction, not the end of the bull market.

This valuation correction started in high growth/GAAP stocks and has spread. For it to be the true end of the bull market, I would have to believe that domestic and global interest rates are about to rise sharply. I absolutely do not think that is about to happen, particularly in Australia, where in a post-Budget world, interest rates are now likely to remain low for longer than was previously anticipated. This view can be confirmed in the flattening yield curves in Australia post the Budget.

But flattening yield curves are a double-edged sword. While they mean low cash rates for longer, they also mean GDP and, therefore, equity earnings growth will be weaker than previously forecast. I think the second part is what the equity market is dealing with now: lower expectations for FY15 earnings growth, based off slower GDP growth assumptions.

However, as that expectation tempering works its way through share prices, we must NOT lose sight of the fact that cash rates in Australia will stay at 2.50% for the foreseeable future. To me, that means that Australian equities will be broadly underpinned by yield support at a point and I think that point is in the 5100 to 5200 range, where the ASX200 dividend yield would be over 4.50%. That index yield also includes low dividend yield mining and industrial growth stocks, which masks the fact that, all things being equal in a pullback, the major banks would be yielding closer to 6.00% fully franked on FY15 estimates, which I think would provide a floor for the banking sector and the market overall.

You can see in the chart below, the ASX Banks Index (AS51 Banks) has been in a clearly defined 5.00% to 6.00% prospective dividend yield trading range since the RBA set the cash rate at the record low of 2.50%.

 

 

Bank outlook

Now there clearly is a chance Australian bank yields could move in the short-term to the higher end of that trading range. Of course, I would reverse our sector downgrade to neutral, back to buy if that happened.

The reason it could happen in the short-term is simple – seasonality and re-correlation to the iron ore price.

Below is a reminder of where the bank sector has come to/from over the last two years, overlaid by a chart of the spot 62%FE iron ore price (green line) and the Australian Bank Index (white line). That may well seem a ridiculous chart but in my offshore marketing, hedge funds have brought it up before and used it as a macro trading trigger. However, they have wised up, they now only seem to tactically short Australian banks ex-dividend for shortish periods (i.e. no divs or franking credits to worry about). This is right now and for the next few months (CBA cum div August). Note in the same period last year (circled) with the overlay of falling spot iron ore prices, the ASX Bank Index fell -15.5% from peak to trough.

 

ASX Bank Index vs. spot iron ore

 

 

Trigger finger

All I am really doing is tactically making sure I am positioned to deploy cash at better risk adjusted value prices in the right Australian stocks over the months ahead. To me, it’s like being a sniper on the hill waiting for the perfect shot at your target. That does require a little patience, but first it requires you to have ammo (cash) to put in the magazine.

So while I think the ASX200 could pull back to the 5100 to 5200 level over the next few months, to me that is just another trading pullback and selective stock buying opportunity on the path to my long-term index target of 6000.

Funnily enough, the final 10% of an index rally is often harder than the first 40%, and that is exactly how this is working out, but as I say above, unless there is a clear change in global and domestic interest rate expectations sharply upwards, then I can see this pullback as being nothing more than a classic pullback in a bull market.

The 6000 mark

That then begs the question, what would we need to see to get the ASX200 to 6000 in the years ahead?

  1. An extended period of ultra-low cash rates.
  2. Banks lowering term deposit rates further.
  3. Credit growth.
  4. Regulatory stability.
  5. The AUD/USD cross rate at 85 US cents.
  6. Rising median house prices.
  7. New home construction cycle.
  8. New infrastructure construction cycle.
  9. Consumer confidence rebounding.
  10. Unemployment peaking.
  11. Iron ore prices finding a level and stabilizing.
  12. Earnings growth.
  13. Consensus earnings upgrades.
  14. Consensus dividend upgrades.
  15. More large scale M&A.

The interesting thing is, all 15 of those points are likely over the medium-term and that is why I think what I am predicting in the short-term is nothing more than a short-term valuation correction, not the end of the Australian equity bull market as such.

On that basis, I am going to be looking for stock specific and sector opportunities at the right risk adjusted prices as the next few months unfold. We need to be patient and disciplined, but ready to strike when the price is right. You will be the first to know when I pull the trigger!

Go Australia, Charlie.

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

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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