Good morning,

After a much needed break over Christmas I’m formally back on the desk as of this week (well, let’s face it I was here after new year but busy doing other things.)

Market conditions have been pretty volatile and tough to navigate over the break, though things are looking better now. I was surprised by the sheer quantum of some of the intra-day moves over the holiday period as well as how long the heightened volatility continued for, in the recent past its been a much more ‘short and sharp’ increase in vol – this time it lasted c.120 days.

Australia volatility index below:

There’s a number of things I kind of ‘penciled in’ to talk about today, though I think it’s probably of greater value to you if we look at some of the key indicators in the economy, what the outlook for company revenues/profits/costs are and drill down into some thematics that might help us make some money in 2019.

For those reasonably new readers, you might be surprised that I don’t forecast indices this time of year. The reason being because statistically, it’s always smart to expect this years returns to be in line with the long term average of 6-8% and the reality that if you own a portfolio of stocks, market returns don’t matter, only the stocks in your portfolio.

Pretty much defensive sectors + resources have done well this month.

Where are we in the business cycle

I’ve thought markets had been exhibiting signs the business cycle had reached the ‘late cycle’ phase for probably 18 months now. Increasing M&A activity, heightened volatility, earnings growth starting to decelerate (not go backwards, just slow in it’s rate of growth) and speculative activity (for which the cryptocurrency craze seemed the ultimate marker) – all pretty textbook signals for those students of history.

And when some geopolitical risk appeared, worries rose that Fed might be raising rates too fast, at precisely the time the US housing market was slowing, and company profit growth was slowing… we saw markets contract fairly aggressively. As the below table of asset class performance vs CPI from Morgan Stanley highlights that despite your best efforts at diversification, there was nowhere to hide.

Currently, based on the numbers, equities look like a decent investment. The forward price earnings ratio is sitting at 14.7x or an earnings yield of 6.80%. The dividend yield is 4.88% (before franking) whilst the 10 year bond yield is 2.27% and rate on a term deposit for 1 year are sitting about 2.85%. Based on analyst consensus forecasts, we will finish the year at 6405 or 10.9% higher or a total return of 15.78% inclusive of dividends – which based on historical error, you better trim back a fraction.

The market is currently pricing in an earnings recession, year on year change in the total return of the ASX 200 vs same in forecast earnings growth… need to mindful of that gap.

With FY19 earnings forecasts being pulled back a bit by the analysts of late, though the downgrades are slowing.

Why the cuts to earnings estimates? Well it’s double whammy from commodity prices, oil and copper below in USD:

And the housing price collapse here in Australia. Most analysts & the leading indicators agree that prices are going lower in the capital cities and this might put a further squeeze on consumption and hold back confidence.

It will, as it often does, come down to the Feb reporting season and the all important outlook statements for many of our companies. All in all, I’m not particularly bearish at these levels, though the Fed needs to keep talking up it’s support for markets if we want to see things continue higher. With all the bearishness in analyst estimates, there is upside surprise risk potential during Feb reporting, though I think punting on results is speculative at best. My focus will be trying to avoid the big misses, rather than necessarily hunt the upside given the economic backdrop.

Movers & Shakers

I’ve sorted this week’s performers but month, so you can see, roughly how well/not well things have done over Christmas. Gold (which is why resources did well), a marginal recovery in IFL and a bit of a bounce in some of the high PE/high growth names (ALU, XRO, APX, BVS, IEL).

Costa Group (CGC) down 32% this week on a trading update, citing weak demand and a shortened season. Whilst the company assures the market that its nothing structural, I’m not seeing a quick re-rate given premium PE to peers globally/narrow-ish moat. Elsewhere, a lot of the recent acquirers took a hit, as did some of the non-bank financials and non-iron ore bulk commodity producers. Consumer exposed SUL and PMV also feature.

Predictions for 2019

As I said, I hate predicting the index but I’ve got a few other calls for you to rub my face in this time next year. As Michael Jordan says, you miss 100% of the shots you don’t take!

  • RBA keeps interest rates on hold all year. Fed raises rates slower than expected.
  • Australian house prices fall by another 5%.
  • Resources stocks underperform Industrials for the first time in 3 years.
  • Spotify (SPOT) gets taken over by Apple (AAPL) in a race with Amazon (AZMN) to rule music.
  • Gage Roads (GRB) gets taken over by some big global beverage company
  • Tech stocks bounce – led by Amazon (AMZN) – as the investment world realise that all the smart people don’t work at investment banks anymore.
  • Spin offs come thick and fast. Amazon to spin of AWS, Westpac to flog its Financial Planning business.
  • BOQ and SUN merger? BOQ and BEN merger? I reckon something gives in this regional bank sector.
  • AUD falls to 65c as US bond yields rise and Aus bonds go nowhere on a flat RBA.
  • The West Coast Eagles go back to back – Nic Natainui wins the Norm Smith Medal against Richmond at the MCG on Grand Final day. Wooden spoon = St Kilda.

Have a good week,