Yesterday, I upgraded our view on Australian equities to ‘bullish’ from ‘selectively bullish’, feeling the headwinds that have driven the heavy underperformance of Australian equities are easing.

My view remains that if you are bearish on anything Australian, it should be the Australian dollar, which in turn makes me increasingly bullish on underperforming large cap Australian equities. As the Aussie falls, this gap will close in favour of Australian equities. I’d be buying SPI futures and BHP shares today, while shorting the overvalued Aussie.

Stay in May?

For the last two years the tactical trading strategy of “selling in May and going away” has worked brilliantly in Australian equities. Thankfully, at a strategy level we have been on the right side of it on both occasions. Will it be third time lucky for that strategy, or is it time to reverse the seasonal playbook?

From May 2010 to July 2010 the ASX200 lost around 800 points. From May 2011 to October 2011 the ASX200 lost around 1,200 points. Obviously, these back-to-back serious corrections make everyone wary of the pending Northern Hemisphere summer, but I think this year the right approach in Australian equities is to “buy in May and stay”.

This should coincide with a period of global stability, remembering the May 2010 and May 2011 corrections were driven, respectively, by fears of a US double-dip recession and the European sovereign debt crisis. Fingers crossed, outside of Iran, Israel or North Korea doing something very, very stupid, I just can’t identify what the next global trigger for another minus 20% correction is. Yes, Spanish bond yields require close watching, but that’s no different to any other day this year.

Look for large caps

Under that overlay and considering the Reserve Bank of Australia will certainly cut rates in May, the Australian banks will confirm record profits and dividends, the Australian dollar should be down around parity, and China will also be lowering its required reserve ratio, I believe there’s every chance the ASX200 – led by large cap laggards – will perform well relatively and absolutely. It may well prove to be the best performing G20 market in raw total returns.

I just think there’s a combination of economic variables in Australia pending that should make households, businesses and in turn, investors, less pessimistic. Even the Federal Budget will be less draconian than the political theatre would suggest, and Australia will keep its AAA rating. (PS. America losing its AAA rating hasn’t hurt it.)

There’s a tonne of cash sitting on the sidelines at the moment with virtually nothing trickling into active Australian equity mandates. My view is as the cash alternative becomes less attractive, due to cash rate cuts, and domestic equities start to slowly outperform, you will see switching at the margin from unfranked fixed-interest yield to fully franked equity yield. That’s one of the key reasons I have a heavy amount of fully franked industrial yield in our high conviction large cap recommended list, alongside China facing resource production growth stocks with corporate appeal.

The high conviction large cap recommended list:

• AMP (AMP)
• Crown (CWN)
• Fortescue Metals Group (FMG)
• National Australia Bank (NAB)
• Santos (STO)
• Seven Group (SVW)
• Telstra (TLS)

Similarly, I believe foreign investors are running large underweights in Australia – the largest in many years – while hedge funds have found our largest stocks to be low-risk regional short funding vehicles (earnings downgrades, no merger and acquisition potential). As the Aussie comes down, that positioning will reverse and we will be surprised by the foreign investor demand for large cap Australian equities.

So I am getting more positive on Australian equities right as recent seasonality would suggest that to be foolhardy. If we can see the Aussie below parity in the second half of this year, and I think that is a very high probability, you will see Australian equities do very well. It’s that simple in my view.

Go Australia, Charlie.

Other recommendations:

Bank of Queensland (BOQ) – Reduce

We’ve revised our projections for Bank of Queensland following its placement of Perpetual Equity Placement Shares (PEPS) to raise $150 million. While we are comfortable with the bank’s credit risk, our previous net interest margin (NIM) decay was too aggressive in light of the recent 10 basis point rate rise and seven basis point free funds effect from new capital. NIM is thus increased by seven basis points resulting in 11% higher earnings per share across our forecasts. This leads us to raise our price target. However, the Reduce rating is maintained given structural headwinds in the bank’s Owner Managed Branch (OMB) model in a low credit growth environment and downside risk from possible changes to the incentive structure.

Prior to the GFC, there was the expectation new OMBs would breakeven close to the end of the first year, with BOQ achieving 15% return on equity from the franchisee after three years. This is unlikely at present with its customers deleveraging and its net interest margin squeezed by expensive wholesale funding. With healthy upfront and trail commissions, the model in our view is biased towards loan generation. Our analysis also suggests that OMB loan growth typically exceeds system when transfer-priced loan yields increase, while deposit growth typically underperforms the system when transfer-priced retail funding costs decrease. Assuming a declining rate environment for assets and liabilities and with the transfer price having rebounded off recent lows, the OMB is probably assured of lower returns that would further crimp BOQ earnings. BOQ’s growth thesis also relies on fresh OMBs coming into the pipeline to build up scale. New OMB entrants appear to have dried up since 2006.

• 12-month share price target: $6.15 (previously $5.50)
• Wednesday’s close: $6.75

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

• Peter Switzer: We’ll begin to catch those Yanks
• Ron Bewley: Why we need to understand volatility
• Andrew Bloore: Personal contributions could be tax deductible