insto - Australian financial markets

The collapse of one-time investment bank darling Babcock & Brown was back in the spotlight last week with former executives facing questions in the Federal Court. Liquidator Deloitte is looking to find out if directors breached their duty to shareholders before the company’s collapse with debts of $3 billion. At its high point, B&B was valued at $10 billion. The hearing saw former chief executive Phil Green and CFO and CEO Michael Larkin questioned over dividend payments, and whether they had been unlawfully paid.

Boston Consulting Group calls it the “regulation tsunami” set to overwhelm the world’s financial system. APRA says it is inevitable, but the local banking industry is wary and resistant. So how will the regulatory push play out in Australia, once all the shadow- boxing is done? By Lachlan Colquhoun.

On The one side, there is the Federal Government and the regulators. Australia needs to be a good G20 global citizen and move in concert with the rest of the world, to make the globe safe from future financial meltdown.

Further ratings agency pre-sale commentary on the 4-class ME Bank deal, initially reported in this morning’s Overnight Credit Report, includes the following :

The end of the third quarter exhibited hallmarks of a true recovery in equities markets, continuing the upward trend that has spanned the previous six months.

Global equity markets were a lot more volatile in early September, however the catalyst that prompted investors to switch back into equity markets was largely better-than-expected economic data. The considerable improvement in manufacturing activity across the globe was the main highlight for investors.

It seems the share market had just found its feet again after the 50 per cent-plus gains since March lows. However, the past fortnight has seen the market fall back by around 5 to 7 per cent on concerns over the strength and durability of the recovery, said Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors.

A year on since the Lehman Brothers failure, Caren Chesler, our US correspondent, sought answers. While the reasons for its demise are becoming clearer under the glare of 20/20 hindsight, what will be Lehman’s legacy is just as opaque as the practices that caused its collapse, as Chesler found…

While Australian 2008-09 profits are down around 18 per cent, making it the biggest slump since 1990-91, it has not been the disaster that had been feared. In fact, the profit reporting season overall has been pretty positive. This is the view of Shane Oliver, Shane Oliver, head of investment strategy and chief economist AMP Capital Investors. The following notes are his observations.

Firstly, positive surprises have dominated making it the best season for results relative to expectations in two years. 44 per cent of results have come in better than expected compared to only 18 per cent below. This is a big improvement on the last two reporting seasons when there were more companies surprising on the downside than the upside. In fact, the net balance of positive less negative surprises of +26 per cent is the best it has been since the August reporting season two years ago, as the chart below shows:

Fig 1: Profit results relative to market expectations

Source: AMP Capital Investors

Secondly, company outlook statements have been far more positive than was the case in the last two reporting seasons. While companies remain somewhat cautious, positive outlook comments have dominated negative comments by a ratio of nearly four to one, whereas in the last two reporting seasons negative comments dominated.
Other key themes have been strong margins thanks to cost control and the economy holding up better than feared six months ago, dividends being cut but not by as much as expected and continued capital raisings in order to reduce gearing and (possibly) fund takeovers. By sector, the key areas of upside surprise were in energy, retailing and capital goods and the key areas of downside surprise were in real estate, transportation and telcos.

As a result of better than expected results and more favourable outlook statements, equity analysts’ earnings expectations for the 2009-10 financial year have been upgraded by around 3 per cent, signalling the likely start of an earnings upgrade cycle after two years of downgrades. The next chart shows that the number of companies seeing their earnings being revised up by analysts for the year ahead now outweighs the number of companies seeing downgrades. This follows two years of net downwards revisions. It’s the same picture globally after better than expected earnings reporting seasons in most countries.

Fig 2: Share analysts' revisions to earnings forecasts are now turning positive

Source: Thomson Financial, AMP Capital Investors

With companies having reduced costs and economic recovery pointing to stronger revenues going forward it’s likely that further upwards revisions to earnings expectations lie ahead. This is favourable for shares.

Are shares now expensive?
There are numerous ways to measure share market valuations. The simplest way to is to compare the level of share prices to earnings and a common approach along these lines is to use the consensus of equity analysts’ earnings expectations for the year ahead. This is usually called the forward price to earnings ratio as earnings are for one year forward. On this basis, global and Australian shares have risen from forward PEs of 8 or 9 times, which was historically low, to now around 15 times which is in line with long term averages.

Even after the rebound in the share market since March, profits would need to fall another 30 per cent to justify shares at current levels. With signs the economy is stabilising and the outlook for profits is improving this seems unlikely.

Finally, it should be noted that our analysis has made no allowance for the fact the earnings yield and dividend yield on shares is now running well above the yields available on cash and bonds, providing another indication that shares are not expensive.

The bottom line is that while the rally in shares means shares are no longer dirt cheap, they are not expensive either and most valuation measures suggest there is still more upside left.