Equity returns hide danger signs

Equities are back, and so is investor interest, with investors returning to shares from defensive asset classes such as property and cash after the exodus of 2000 and 2001.

The top 10 performing diversified funds, that is the best the market could offer as measured by Assirt, on average returned 24 per cent in 2003 compared with 3.17 per cent in 2002 (table 1). The top 10 international equities funds returned an average of 28.64 per cent in 2003 compared with -5.84 per cent in 2002 (table 2).

But should you be rushing back into equities to take advantage of these great returns? The answer is ‘yes’ and ‘no’ because despite a stellar return to form last year, it is unlikely equities markets will continue in the same vein, but rather settle down to a more realistic level of returns.

BT head of global asset allocation Callum Burns says the reason for the bumper year in 2003 was that prior to the war in Iraq, equities around the world had been heavily sold down and the underlying values much reduced.

As a result, when the equities market came back, many stocks were very cheap, resulting in good performance and strong returns seen by many investors and managed funds.

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“Returns have been driven by a re-rating of the market in which the capital value was too cheap as investors had become overly fearful and in turn had sold equities below fair value,” Burns says.

Colonial First State head of investments market research Hans Kunnen says while the war had an impact on the return to form for equities, it was a return to positive market sentiment that was one of the key drivers.

“The rebound in earnings after 18 months came on the back of a growth in positive market sentiment. The war in Iraq did have an effect, but the results of many listed companies were still good and this was reflected in returns.”

Kunnen says the Iraq conflict did serve to clarify issues with a swing in thinking to focusing on the fundamentals of equity investing such as yield on shares, earning and profitability.

“In the US there was some assistance from tax cuts, Government spending and a weakening of the economy. In Australia low interest rates and the building boom also helped to give equities a boost,” he says.

Both Kunnen and Burns see 2003 as an exception for equity returns, labelling it a spike after a very low period, and do not expect to see the same returns in 2004.

“We will see returns driven by profit growth and dividend yield, but it will not be as good as 2003 which was a correction year, and on our measures, had come off the back of the highest degree of undervaluing in 30 years,” Burns says.

Kunnen characterises it as a spike after the doldrums, “and there will be a return to normal levels as locally the market cannot sustain 12 per cent growth each year. Rather, growth will be more in line with the economy than ahead of it.”

They also state the Australian market will be able to sustain high single-digit returns while international equities would post low double-digit returns without adding the issue of currency.

Is it worthwhile making the journey back to Australian and international equities, particularly with outflows coming from cash and property investments?

Burns says it is time to look at equities again as markets are back to acceptable levels, despite the possible bouts of volatility, with some cheap stock opportunities still on offer.

Yet he offers a warning for those advisers and clients who are considering a sizeable shift back into equities.

“Keep an eye on earnings growth in both Australian and international equities as it will be a strong indicator of what lies ahead, as will 10-year bond yields,” Burns says.

“If bonds go through a significant rise, such as 100 basis points, it is a sign to be more cautious since a rise in yields will pressure equities as they compete for funds.”

Kunnen says earnings will be a key indicator and points to the good returns from technology stocks in the US, but says the underlying earnings are still poor and investors need to look at who will be making profits and why.

“It’s just a matter of looking at who is paying real dividends in real dollars or rather just returning accounting profits on paper in the way Enron did,” Kunnen says.