Wednesday, 4 January 2012

ASX Fair Value 2012

Australian Share Market Outlook in 2012

2011 turned out to be a very difficult environment in the markets for most people, which is a result of substantial ongoing volatility and broad market declines. We have seen ongoing difficulties in the sovereign bond markets, with a particular (and tiring) focus on Europe which seems never-ending. Overall the financial sector globally has been one of enduring stress with the wax and waning impacts of coordinated interventions followed by systemic de-leveraging and capitalisation issues. So we have had the ups and downs without any consistent direction. Neither have we had any solution to the problems, as there isn't any easy answer. The problem of too much debt in the system is being answered by financial repression: the artificial suppression of interest rates in conjunction with continued currency devaluation. The end result is that negative real interest rates and currency devaluation support share markets.

I have been focusing on the fair value of the markets. I believe that this provides an insight as to the fundamental under-pinnings behind them and gives me confidence in being able to see the big picture. To do this, I have been looking at important company statistics such as cash balances, cash flows, revenue, share issuance, changes to debt levels and so forth. However, whilst these factors highlight stresses or positives in the system, in the end the market is generally priced based on earnings. In particular - forward earnings. The market already knows what earnings have already occurred, and on a broad basis it is efficient based on past data, however the trick is to have an idea of what earnings will be in one or two years time - and hence my thesis is that current prices tend toward fair value based on these future earnings.

As shown above, this is the value trend that we get when using fair value based on past earnings, however it is based on forward earnings - not current earnings. Therefore it works very well as long as you know exactly what is going to happen in the future, which is not feasible. So what happens in reality is that the fair value is constantly being moved on the basis of earnings forecasts - and these forecasts change frequently. This isn't so bad as long as you are adaptable and can adjust as the climate changes. However it isn't ideal. During the lead up to 2007 this graph would have looked differently as analyst earnings forecasts would not have considered a huge drop over the following couple of years - it would have increased during 2006 and 2007. Nevertheless, it is a very useful gauge and can highlight substantial discrepancies between price and fair value.

The forecast earnings trend over the past few months has deteriorated consistently. Therefore fair value as obtained based on earnings expectations 90 days ago would have been higher compared to current earnings forecasts. This is a process of constant reassessment. It is for this reason that I have created a second fair value indicator - one based not on actual (or forecast) earnings, but based on solely on economic indicators - meaning that earnings are completely disregarded! This may sound strange but if one accepts that future earnings are unknown today, but that fair value now is determined based on the expectation of those future earnings, then it is more useful using the economic drivers than the earnings themselves. This applies to the market broadly, but not so much for individual companies (unless their earnings are highly correlated to market earnings). One thing that I have not previously done is to chart out the past performance of the economic fair value indicator. I have now done so and in my view the results are powerful.

The economic indicator is based on actual known information at any given point. Unlike consensus earnings forecasts, it does not rely on constant revisions. For this reason it is much more powerful. It is also very clear that it provided a strong indication of a strong upwards move in the markets during 2003 to 2007. It provided a early and stark warning in 2007 - with the trend crossover in around April of that year. It provided ongoing warnings of a decline in fair value through to 2009. It showed recovery in 2009, however it has not been as optimistic as the market - and it appears for good reason. The ASX S&P200 / XJO index is now roughly where it was in July 2009! The good news is that this indicator is now showing the market slightly below fair value - for the first time since late 2006.

What is the economic indicator that I use? It is a non-equally weighted modified index of important US based economic indicators that include: capacity utilisation, business inventories, PMI manufacturing index, new orders, M2 money supply, treasury rate, corporate bond yields and financial stress index.

I did not create the index to provide a post hoc curve-fitting exercise, but solely to create an indicator that approximated forward earnings. It makes sense that often earnings will be not always be representative of real economic gains, due to accounting adjustments, so the economic indicator is useful to provide a comparison point. As shown to the left, earnings per share are frequently different to the earnings indicator, however fair value as derived by the earnings indicator can change substantially more than the percentage change to the earnings figures - as demonstrated in 2007.

2012 Outlook

Whilst there is a lot to worry about (understatement) throughout global economics - government debt problems throughout the world, banking debt problems, a China slow-down and so-on, the potential impact on real economic earnings is unknown. Sometimes things can change unexpectedly. Therefore it is best to invest on tangible information as opposed to greed and fear.

Economics changes frequently, but often works within a trend. Right now, and since 2009, the trend is up. More importantly for the first time since late 2006/early 2007 fair value based on my economic indicator exceeds the market price. Whilst market price will frequently diverge to measures of fair value, it will move towards it. In addition fair value based on consensus earnings forecasts means that the market is cheap. Whilst I don't expect any major upswings, fair value is headed upwards. Should this trend continue, we could see 5000 again in 2012.

With this in mind, and unless economic indicators fall apart, any short-term price correction should be considered as an opportunity - 2012 is the year of continued volatility, a likely surprise move upwards and continues to be a market where individual stock selection is exceptionally important. My preference is for defensive sectors (e.g TLS WOW CCL), I continue to be adverse to iron ore companies and banks and remain positive on precious metal producers.


  1. Dear Macros

    What can I say? Your graph makes Leonardo’s paintings look graffiti.

    The graph seems to imply you have found the long sought-after holy and magical formula to predict, within reasonable limits of error, the broad rise and fall of the market index.

    While I’d love to follow and test your work, my most disinterested advice to you is this: if you really believe in it, commercialize it (with the appropriate protective disclaimers, of course).

    Refine it, put it in a bottle, sell it and try for your fortune. Good luck

    Ceteris Paribus

  2. Ceteris Paribus, thanks again for your very kind words.