Chris Forrest- Partner and Principal Adviser
Sovereign Wealth Partners
“Past performance is no indication of future performance” – sure, we all know this but do past returns tell us anything?
We at Sovereign regularly attend fund manager briefings, technical sessions and portfolio construction forums. We seek to learn what’s new, how it might be different this time, what new trends are arising and old ones abating. Markets keep changing and we need to stay informed. What does not change is the unpredictability of markets which is driven by the evergreen human motivators, fear and greed.
These two emotions can make markets sometimes appear completely irrational. This isn’t something to fight – whatever the market does, it’s right. But it may not be right for you. Or as the famous economist John Maynard Keynes put it “The market can stay irrational longer than you can stay solvent”. This means investors should understand their capacity, their own emotions and invest accordingly.
We recently attended a briefing where we were presented with many slides, a few of which stood out. Let’s take a look at what may appear irrational. The table below shows the returns of different sectors of the Australian share market alongside the price to earnings ratio (p/e) forecast for the next twelve months (NTM) as at December 2018 and as at 2019. The fifth column expresses as a percentage the p/e increase year on year. The last column is the most telling – this is the change in earnings expected over the next twelve months.
Taking a look at the first sector, Healthcare, we can see the 2019 return was 44.9%, the p/e forecast for 2019 was 24.9, the pe forecast for 2020 is 35.7 and the expected change in earnings is 5.6%. In other words the p/e ratio has expanded 43.2% on earnings growth expectations of just 5.6%.
Another startling example is banks: the lowest return for 2019 at 9.5% but p/e expansion of 26.4% when earnings are expected to decline by 13.8% in 2020. Why are we paying more in anticipation of going backwards?
Perhaps we are seeing investor capitulation: in the face of low interest rates, more investors are paying more for higher cash yields. Can this last?
There are two ways the p/e. can fall: 1. The markets sell off with little to no change in earnings; and 2. Earnings rise with no change in share prices. If the former, at what point does the market say “too much is being paid for these yields for the risk being taken” and what would be the trigger for this realisation to see a sell off?
P/E expansion is not a new thing. Nor is p/e contraction. In fact, the second half of 2018 saw p/e contraction. The chart below shows the makeup of Australian equity returns since 2001.
Dividends will always be a positive contributor to returns. Earnings and value expansion are variable and may be positive or negative.
2018 was a year in which valuations contracted as earnings expanded. Rational thinking would perhaps expect no or some valuation expansion but not valuation contraction.
2019 was a year when earnings in the Australian market contracted yet valuations expanded.
Interestingly, 2009, the year the markets bottomed at the end of the GFC, also saw enormous multiple expansion and a terrific return from equity markets followed by two years of earnings growth and some p/e contraction.
You might ask, if 2019 was such a great year, can we expect to give some back in 2020? Perhaps, but the market is unpredictable. The driver of multiple expansion with modest earnings growth has been falling interest rate expectations. In the second half of 2018, we saw markets sell off on fears of economic fallout from the trade war between China and the US and fears the US was raising interest rates too much too fast (before the Fed’s famous backflip in January 2019).
As it turns out, we believe the economic outlook for 2020 is fairly balanced. There are positive monetary and fiscal conditions in place and the macro trends look sound – this is offset by expectations of weaker corporate profit growth and forever higher levels of debt. If interest rates are set to stay low, growth assets offer compelling yields and their high valuations may continue to be supported. So, what might we expect in 2020? Perhaps more modest returns than 2019 that are not supercharged by valuation expansion but supported at current levels by ongoing demand for yield.