Welcome to the May edition of the Burrell Blog for 2017.
Possible Xfactor – USA Market Correction
The graph shows that the US Dow Jones Index fell from 14000 to 7000 during the Global Financial Crisis (GFC), recovered to 10000 by October 2009 and then continued to gain back above its pre GFC highs attaining a level of 18000 in December, 2014. The Dow held the 18000 level for some 2 years, during which period gains in Australia on overseas direct shares and managed funds were due primarily to the currency falling from $A/US $1.10 to .70, as well as some active stock selection gains. Since November 2016, the Trump rally has pushed the US index above 20000.
The US share market performance contrasts with Australia. While the Australian index also fell by approximately half from 6800 to 3200 and then recovered in the October of 2009, the Australian index went much more sideways and at the Brexit lows in June 2016 was not much above halfway back being around the 5000 level. There has also been appreciation in the Australian market over recent months, currently trading above 5900. However the initial conclusion is that the US market and the Australian markets fell by about the same, but the US market is now at higher valuation multiples than the Australian market.
The most recognisable measure of valuation is price/earnings (P/E) ratios. The table indicates that Priceline is on a PE of 300x, Amazon 177x and Netflix 205x. At the other end of the scale, Johnson & Johnson 19.5x and General Motors 5x.
So what is a sensible P/E ratio? When the writer attended university, a year or two ago now, we would say that for a stock which is not growing we would pay 10x earnings ie. a PE ratio of 10. For the banks that have credit issues once in a decade, the PEs were around 12/13x. For stocks that were growth at reasonable price stocks such as Wesfarmers with Bunnings (and prior to Coles acquisition), a PE of 15x for 15% growth and a 5% fully franked dividend was the benchmark. For companies that are growing at a higher rate, then one should be prepared to pay a higher multiple, so 17x for a growth of 17%, up to 20x for growth of 20%.
By this measure the US market is overvalued. A key issue in post GFC times has been the fall in interest rates. We had a client return from the USA who was earning 0.24% on deposits with the local USA bank. Against this stocks with yields over 2% look attractive, particularly when there has been good growth in the US economy under Obama and likely to be further stimulation under the current president. This gap between historically low interest rates and dividend yields makes the market vulnerable to recovery in US interest rates towards normal levels. The US 10 year rate has fallen from its longer term averages around 5.5% to a 1.4% low in late 2016, before a rally of approximately 1% in sympathy with the post Trump election rises. Similarly in Australia the Australian 10 year bond has fallen from 6.5% to a low of 1.8% in late 2016, before a rally of around 1% to 2.8%. These long term bond rates remain low and if there were to be a rapid increase, equities markets would catch cold. However Janet Yellen, the chair of the US Federal Reserve Board has stated that US interest rates will gradually return to normal and then defined normal as being not too far above the current levels. It is widely anticipated there will be two or three interest rate rises in the USA in this year, of which one has already occurred.
The US market table of P/Es indicates some repeat of the 2000 technology bubble. During that bubble, anything to do with the internet was apparently worth enormous amounts of money and Microsoft reached a lofty /PE of 100x. Burrells commented at the time that Microsoft did not need to make a loss, but that if the growth rate slowed as it inevitably does as companies become larger, then the P/E would contract. It so happens that earnings were approximately $1 per share at the time and so the stock fell to $50, then $25 and then finally bottomed around $US15. It is only in recent years that the stock finally recovered above $30. This salutary lesson seems to be forgotten by current buyers of Amazon, Netflix and Facebook who seem more interested in eye balls and revenue multiples, and not whether the companies make a profit. There is no doubt that a day of reckoning will occur for the valuations on those stocks. On the other hand some of the technology stocks in the old world such as Cisco and Intel, pharmaceuticals such as Johnson & Johnson and General Motors appear reasonably priced as does Ratheon in the defence sector.
However our central case is that the current US president will experience of deja vu with the Reagan presidency. There was also an earlier rally on Reagan’s election when promises were made for halving tax rates etc there were arguments that cutting tax rates actually meant people would earn more and pay more tax. This is simply baloney and if you halve the tax rates, you tend to collect half as much tax. For that reason the current policies have little in the way of credible economics support. In the Reagan era, the issues around balancing the budget, which were much easier at that time than now, meant that the Reagan tax cuts did not really come to pass until the first year of the second presidential term ie. year 5. By the end of the second term, the failure to raise additional tax meant that there was back peddling in terms of the tax cuts.
The Burrell central case is that the US market will suffer a similar “rubber hits the road” moment and correct by around 10%, most likely sometime in 2017. For this reason we have been happy to carry additional cash balances of around 5-10% and deferred some overseas investment into direct equities and managed funds.
The last table shows a selection of Australian PEs and yields. It will be seen that the Australian market is trading at reasonable PEs on average, subject to the company showing a measure of growth. There are some exceptions, and a buying opportunity that may well arise if the US market were to take a breath.
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