Why buying on a dip makes sense

Tony Davison

A Bloomberg national poll in the US has found that 63 per cent of Americans believe there will be another financial calamity of global financial crisis proportions in the next few years.

The apprehensive feedback from investors illustrates the scepticism towards the current bull market, which is in its ninth year. You could replicate the poll results in Australia. Local investors are no different in mindset to their US cousins, perpetually wringing their hands that a crisis our country barely experienced in 2008 is almost upon us.

To my mind, sceptical investors are a sign of a healthy market and suggest to me that in the big picture, equity markets have further to run. We are a long way from the speculative excess that characterises a market at the top. Nonetheless, most market rallies are punctuated by periods of volatility, and equities have the potential for a small selloff soon, which will represent an opportunity for the canny self-managed superannuation fund trustee.

There are two reasons equities are prone to a selloff.

The first is valuation. Australia, the United States and most developed markets are approaching the top end of their historic valuation ranges when measured on a price to earnings basis. On a forward basis, US market valuations exceed their five-year average on the measure by about 14 per cent, with Australian shares overvalued by 6 per cent.

This measure of valuation is in contrast to the dividend yield. For both markets, forecast market yields are lower than their five-year averages by about 5 per cent (not to be confused with percentage points), implying valuations are, again, above average.

Rates start to rise

Interest rates over the past five years have generally been declining, and are now rising as central banks, including our own Reserve Bank, indicate they are gradually turning off the monetary spigot. This could mean that high yielding stocks begin to look expensive. The second issue is unique to the US and involves the timing and earnings assumptions for stocks associated with US corporate tax reform.

Surveys suggest that most market participants expect US corporate tax reform to be enacted later this year or early next year. If the timing is pushed out or the reforms diluted, earnings expectations for US companies would be downgraded, leaving the US market looking expensive.

I don’t doubt reform will be enacted, but timing is uncertain. (Witness the legislative difficulties associated with health care reform.)

The bottom line is that valuations are stretched, and by quite a margin if tax reform is not delivered in the US. Presuming we saw weakness in US equities, this would carry through to Australian and global markets. If, as we suspect, equity markets fall 5 to 8 per cent on the back of these or other unidentified issues, it would provide an opportunity to buy. Preparation is key to taking advantage of any such opportunity.

We would look firstly to international equities, as the prospect of capital growth is much higher in overseas markets than it is in Australia. Broad exchange traded funds (ETFs) such as Vanguard’s VGS or iShares’ IWLD provide low-cost exposure to global share indices. Sector wise, we like technology. It’s fuelled most of the growth of the US markets in the past few months. Cheap exposure to the US technology sector can be found through ETFs from Betashares’ NDQ.

Promise of more returns

On the Australian market, if there was a good buying opportunity, we would add to our Macquarie Group, CSL and Ramsay Healthcare positions, as these are companies which we believe will continue to deliver returns for shareholders.

We’d add back real estate investment trust exposure through Stockland, as the sector is looking like it’s reached the bottom of its valuation range after the recent weakness.

We’ll also add commodities through the majors BHP, Rio Tinto and focused commodity plays such as OZ Minerals and Fortescue. It’s seldom trustees have enough exposure to the commodities sector and they look cheap if the global economy improves.

Longer term, benign monetary policy, the virtual absence of inflation and healthy labour markets offer a favourable macro backdrop, while moderate economic growth and good business confidence numbers are supportive to earnings growth – all of which is good for equities if they’re appropriately valued.

For these reasons, we’ll be keen buyers in any dip.

Tony Davison is general manager and senior financial adviser at Henderson Maxwell, hendersonmaxwell.com.au

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