What is in store for the markets, 2010 and beyond?

Shaun le Roux of Alphen Asset Management writes that it is almost not worth trying to guess what is in store for the markets next year.

Markets are no longer cheap and the world has many problems. South Africa has its problems and these need to be dealt with once we get through the euphoria that will accompany the World Cup. Yet, Mr Bernanke and Co seem content to throw money at the problem(s) and this money has to find a home. Markets could rise in 2010 and if they don't they will almost certainly be down.

All our research points to the benefits of focusing on the opportunity for long term returns (after taking into account the risk of not achieving such returns) rather than trying to predict short term movements. If your investment horizon is long enough, history can tell us a lot about what to expect. Combine history with solid fundamental analysis of valuation levels and a smidgen of crystal ball gazing and one can hopefully formulate sensible investment decisions. Well, that's the theory anyway.

The graphs below are insightful in terms of what history can tell us.

The top graph is the JSE All Share adjusted for inflation. Importantly, it excludes dividends, and as we have repeatedly indicated, dividends provide the majority of the long term return from equities. So, what we are looking at here is long term real returns generated by movements in share prices alone.

The bottom graph is the PE (price-earnings) ratio of the ALSI over the past 49 years. It can be distorted by large swings in earnings, such as in recent times. But, it is a useful indicator of broad valuation levels.

Some of our observations:

Buying into expensive markets gives rise to poor long run real returns. Take a look at 1969 when the ALSI PE ratio breached 26. It took the market 35 years to sustainably surpass this level (in real terms). Similarly, the S&P500 in the US is still 45% below its peak in 2000 after adjusting for inflation. The 2007/2008 high on the JSE on this basis is also unlikely to be surpassed for some time.

After short sharp periods of price appreciation the stock market tends to endure long protracted periods of sideways movement. Refer most of the 1980s and 1990s, two decades that were characterized by broad trading ranges. During this period a strategy of buying when the PE of the market traded below 10 (and particularly if it got close to 8) delivered good results if you were firstly prepared to be patient and secondly sold when the PE ratio was high again. A good level to sell the market was when the PE ratio nudged above 16 - the black line on the bottom graph. If you bought the market on a PE ratio of above 16, the real capital returns (based on price appreciation) were typically muted for several years thereafter.

We all know what the JSE did between 2003 and 2007, an example of a short sharp period of price appreciation and a bull market of note. The stock market enjoyed very healthy profit growth as well as an expansion in PE ratios. 2008 saw peak earnings for many companies and we certainly don't anticipate a swift return to those levels of profitability. Unfortunately, the market rating (PE ratio) in early 2008 was also steamy, just when profits were peaking, so it is highly probable that it will be some time before we take out the market highs of early to mid-2008, particularly in real terms.

We consider it highly likely that global equity markets will find themselves range-bound for the next several years. A move to take out the previous highs will require either a robust profit growth cycle or an equity bubble. Our base case is that the profit cycle will be muted. We do see profit growth in 2010 against the low base of 2009, but that such growth will be somewhat technical in nature and profit levels will remain far short of 2008 for some time to come. It is difficult to see what will kick-start the global economy once government intervention peters out and the de-leveraging process continues on its inevitable path, meaning growth in credit extension continues to be feeble at best. As the last year has shown, the South African economy and stock market dance to the beat of the global growth drum.

It looks, with hindsight, like the valuation levels of March of this year provided an excellent buying opportunity . Interestingly, at that stage nine months ago the ALSI was trading on a PE of 8 - a good entry level for patient investors based on history. Also intriguing is the fact that the market currently trades on a PE ratio of 16 plus, the indicative selling level for range-bound markets.

It is worth noting that the main risk to selling this market is that a meaningful profit cycle does manifest itself. In that case selling these levels could prove as painful as selling out in early 2006 when the market breached the 16 PE level and continued to run for two years thereafter. The other risk of reducing equity exposure is that an equity bubble develops. It is possible in this environment of high liquidity but we prefer not to speculate on such uncertain outcomes.

So, if our prognosis comes to bear and range-bound markets lie ahead for us, active portfolio management can add to performance if investors have the stomach for the patience that is required. Accordingly we continue to advise that investors keep some powder dry to be employed when the current appetite for risk diminishes. By extension, more active investors that have enjoyed the rally may want to consider taking some money off the table.

With valuations looking like they are approaching the top end of the range, Alphen's portfolios have a strong bias for higher quality companies offering reasonable value as well as visible and defensive earnings. It is our belief that they will provide investors with attractive real returns over the years ahead, regardless of what 2010 holds in store.

We do not advocate a wild trading strategy that involves trying to time the market. Instead, we are of the view that portfolios can benefit from sensible active asset allocation and stock selection, particularly in the case of markets trapped in a trading range. This involves selling the upper end of the range, being patient, buying the bottom end of the range and guess what, being patient.