Timing Tool
By Rome Mostert
Our timing tool considers the market’s sentiment and valuation in order to estimate a probability that the market will be up over the next three months.
What we witnessed since early 2012 is that market sentiment was fairly upbeat, with more stocks trending higher than the long term average. At the same time we saw valuations moving into expensive territory and remaining expensive for most of 2013. Despite seemingly stretched valuations we have shared our view that we are not unduly concerned over market levels as long as earnings are up to expectations as expectations reflect a fair degree of growth.
The strong JSE earnings reports for December 2014 saw the PE multiples declining into the 7thdecile relative to historic averages. The valuation rating relative to the positive sentiment saw us issuing a very bullish view in April 2014.
Since the previous Elephant Book we saw the Top40 Index increasing 7.7%, coincidently taking the PE multiple back up to the seemingly expensive levels seen for the most part of 2013. The PE levels together with the continuing strong market breadth continue to predict positive market returns, with probability of 52.2% for positive returns going forward. However, the market is increasingly reliant on the upcoming earnings reports to justify the current levels. The Top40 is trading at 15.4x and 13.9x CY14 and CY15 earnings.
As a result, we are cautiously optimistic heading into the new quarter, awaiting JSE earnings report and should it meet expectations or beat, we will happily change gears with eyes on an end of year rally.
Recommendation
With our view that the global business cycle has entered the late expansion phase, we foresee that growth and inflation forecasts will start to see some upward revisions coming through (as opposed to a long streak of downward revisions) as global economic momentum starts gaining traction. Based on this we keep our recommended asset allocation unchanged with an underweight in bonds, neutral on cash and overweight equities.
We anticipate that bond yields will move gradually higher over the medium term as the market starts pricing in the probability of central banks tightening money supply. However, we do not foresee a significant spike/overshoot in bond yields as it is important for central banks to keep managing the trend in order to avoid the detrimental impact of higher finance charges to the global economy. South African bonds, however are expected to show increased volatility on account of the bearish rand sentiment. We recommend an underweight in bonds and income yielding instruments (with a limited growth profile). Within the bond asset allocation we do however prefer longer duration over shorter duration, based on the view that the yield curve has factored in the interest rate hiking cycle at the long end, with the shorter end set to react and be more sensitive to the actual increases.
We take a neutral view on cash. We do, however, prefer it over bonds, but prefer equities over both. We recommend tying a combination of floating rate notes and inflation linkers with the cash position to achieve some yield pickup.
Given our view that the late expansion is only commencing, we expect to see momentum in corporate earnings growth over the next 18 months, which in turn bodes well for equities. We recommend an overweight in equities with the view that the second half of the bull rally has only started and is likely to persist for at least another 12 to 24 months. We do, however, expect investor nervousness, on the back of increasing bond yields, to result in an increase in market volatility.
Our most and least preferred stocks are as follows:
Source: IJG