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What could be driving record market levels?

17 Apr 12          

Daniel Isaacs from 360ne Asset Management writes that there is a puzzling phenomenon in the current markets; every day the news is full of negative sentiment on the state of the global economy, from Europe entering a recession to a sharp slowdown in China and yet the JSE All Share Index is trading around all- time highs

Looking at the level of the market it is apparent that the peak the market reached in 2008 pre the crash was surpassed in January this year.

How does one make sense of this phenomenon? As we know, the markets are forward looking so prices adjust to what is expected, and the expectations pre the crash were very optimistic. So are we really back to that same level of optimism? Not if you read the news.

The first thing to note is that these positive expectations are not widespread across the whole market. This seems to rule out expectations of a generally better global outlook that would benefit all sectors significantly. We can use a simple analysis to see this by breaking down the market into resources, financials and industrials (using the Resi20, Fini15 and Indi25 indexes as basic proxies) and comparing their 2012 and 2008 peak levels. After performing this analysis it becomes clear that industrials have been the major contributors to the markets performance. However this still does not answer the original question of how a peak market level coincides with a subdued global outlook.

One of the keys to this answer is found in the question. The subdued global outlook itself is partly responsible for these market levels. This is perhaps counter intuitive, until one considers that the price investors are willing to pay for something is not only based on that something, but on what they can get if they went elsewhere.

These comparisons play out in a few ways: internationally, locally and between different types of assets. On the international front, developed markets are still dealing with the issues caused by the financial crisis, leaving them with all-time low interest rates and low growth. Locally, concerns over the magnitude of China’s slowdown and therefore the effect on the demand for the resources the mines produce are keeping a lid on the prospects for the resource sector. The banking sector has also not had an easy time with an already indebted consumer, a muted housing market, and pressures on fees. Generally speaking this has left non-resource and non-financials as the favourites. 

In a world full of concerns and subdued returns the race is on for assets with good returns. Put another way, good returns are priced as if they are great returns. As an example, in the local market we have had retailers trading on a 20 times price to earnings (p/e) multiple whereas their average multiple over the last few years has been low to mid-teens. In other words if you were paying a 15 times p/e multiple and are now paying 20 times, you are effectively paying over 30% more for every Rand the company earns. This may seem like a big jump but it is a lot more palatable if other opportunities have dried up.

So whereas the market peak before the 2008 crash reflected a general optimism of all good things, current peak levels are more reflective of a desire to find a decent return while the world chugs along to recovery.

Now that we are aware of this phenomenon, we can be ready for the corollary of this situation. When the news flow improves, instead of thinking our star performers did so well when times were bad that now when times are turning good they are really going to shoot the lights out, we can understand that if their performance starts to wane it can be somewhat attributable to their relative attractiveness decreasing as other assets start to recover.

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