From top-down to bottom-up

There is still a lot of gloom being written about in the financial world. 

Source: Bloomberg

We are hearing about mass over valuations, that the ease of credit is going to create bubbles, and that global economies are teetering on the edge of disaster.

I am not saying that some of these calls are not possible, or correct; I believe that they fail to really address what is being seen here and now. I understand that these calls are future calls, and there are signs of strain in pockets of Europe and that price earnings multiples in pockets of the US and Australia are overvalued.

However, the market has continued to defy these calls and has quickly punished any of those trying to position themselves against it. For example, the S&P, which has been unloved, unwelcomed and defied these past five years, is back within two points of the record high seen on July 24. The trend suggests that it is only a matter of time before this level is broken.

So what does that make the pullback seen since the high four weeks ago? It is just that - a pullback. The trend has held true; the futures have not experienced a 5% or more pullback since November last year, nor have the fundamentals turned on the index. The pullback was a chance to revaluate stretched valuations and reposition once more, as geopolitics saw volatility increase, which saw profit taking.

So why has the five-year rally continued with valuation now back at levels seen near the July high?

First, the top-down macro theme of ‘lower for longer’ from central banks is not only holding true, but looks immovable. Despite slightly more hawkish talk out of the Fed minutes overnight, it is still hard to see the Fed funds rate rising in the next six months. Australia is welded to ‘period of stability’ in rates and therefore will have record low rates for another 12 months at least, and Europe could see rates even lower if macro themes in the eurozone remain. This has led to a theme that all equity markets have experienced on the back of this top-down policy – bottom-up support of the yield trade.

This brings me to the second part of the answer to the question above: equity valuations are on an absolute value, almost touching fair value. However, this is comparing relative valuations, like equity yields in the US for example that are touching those of credit papers with a BBB rating.  In the Eurozone, equity yields are touching a B rating. This offers an interesting conclusion; either stocks yields are overpriced or credit papers in the US and Europe are too low. The other conclusion is that equity prices have upside as yields are too high and need to come down and funds are likely to come from treasuries.

In Australia, the yield trade has already seen equity yield curves in traditional plays coming down to fair value. However, earnings season has actually seen this trade come back, as return of capital has driven price action. Special dividends, share buybacks and increased payout ratios have seen the yield curve in the Australian market steeping again, and with the RBA (as categorically as it can) stating in the Standing Committee testimony that is not ready to rise rates - the yield trade is here to stay as long as ‘lower for longer’ remains.

Prime example is the price recovery in CBA since turning ex-dividend. Its results were in-line and FY15 outlook looks flat, however its share price is within $1.20 of its closing price pre its FY14 numbers. I can also point to price action in WES as its special dividend has seen it making a record all-time high and TLS seeing sustained bidding on its increased dividend and its $1 billion buyback.

What is clear from the market reaction in the US, eurozone and Australia is top-down and bottom-up views are likely to help indices keep their foot on the peddle until relative valuations and absolute valuations meet.

Ahead of the Australian open

We are currently calling the ASX 200 up 28 points to 5663,after having reached a six-year closing high yesterday, even with BHP dropping anchor and pulling mass points out of the market. The moves in BHP were short-sighted and are likely to be those bailing as no capital management was forthcoming and have switched into other plays, with higher short-term payouts, therefore BHP is likely to see some bidding and may recoup parts of the losses seen yesterday.

 It is also likely that a sustained, broader market bid up will continue, which could see the market reach a level not talked about since June 2008, as earnings season continues to allow investors to hold the line.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

Find articles by analysts

Een artikel zoeken

Form has failed to submit. Please contact IG directly.

  • Ik wens per e-mail informatie van IG Group bedrijven te ontvangen over handelsideeën en IG's producten en diensten.

Voor meer informatie over hoe wij uw gegevens mogelijk kunnen gebruiken, bekijkt u ons Privacy- en toegangsbeleid en onze privacy website.

CFD’s zijn complexe instrumenten en brengen vanwege het hefboomeffect een hoog risico mee van snel oplopende verliezen. 79% van de retailbeleggers lijdt verlies op de handel in CFD’s met deze aanbieder.
Het is belangrijk dat u goed begrijpt hoe CFD's werken en dat u nagaat of u zich het hoge risico op verlies kunt permitteren.
CFD’s zijn complexe instrumenten en brengen vanwege het hefboomeffect een hoog risico mee van snel oplopende verliezen.