The ASX 200 ended December 2006 at 5644. The index peak, hit only last month, was 6873 for a return of 22%. The most recent low was 5670 in August, very close to the earlier March low of 5642. At yesterday's close of 6280 the ASX 200 is up 11% for the year, pretty much all of which has been regained since August. In any other decade this would be considered a pretty pleasing result. But returns in the last couple of years have been such that 2007 actually looks a bit disappointing. We can put this down to the subprime crisis.
That's all well and good if you are an index tracker, but if you are a stock picker you realise that all the year's index movement has been concentrated in a small selection of stocks, mostly in the resource or related services sectors. Rio Tinto (RIO) was up 76% and WorleyParsons ((WOR)) up 128% as of yesterday, for example. There have been other success stories, such as fertiliser producer Incitec Pivot ((IPL)) up 202% and biotech CSL ((CSL)) up 62%. And, of course, there's Fortescue Metals ((FMGDA)), up 426%.
The resource and related sectors were hit by the subprime fallout initially, until the market realised there was little connection. The same cannot be said for the banking sector however, which has had a mixed year. Analyst favourite Westpac ((WBC)) is up 14% while unfavoured National ((NAB)) is down 10%. And we won't mention some of the smaller financials.
It has taken analysts all year to figure out that an increased cost of credit was likely to weigh on those stocks which are heavily borrowed, just as it took most of the year to figure out a higher Aussie dollar affects export receipts. No more glaringly obvious has the former case been than in the tale of Centro Properties ((CNP)). Centro has caused a big downer in the lead up to Christmas, in more ways than one. But what both the REIT crisis in particular and the subprime crisis in general have achieved is an element of confusion and fear in the market, and such circumstances usually lead to certain stocks being sold below their reasonable valuations.
Today some of the brokers have taken the time in their daily reports to analyse just what sectors and stocks might now be oversold, and thus what we might call the "summer specials".
GSJB Were has had a look, and the analysts have suggested that uncertainty will linger in debt markets and as such a defensive bias should be taken. In order to shield from credit problems, Weres recommends stocks with resilient cash flows, low interest rate sensitivity and strong balance sheets, and particularly stocks which have become attractively priced.
From a sector point of view, Weres is favouring Insurance & Wealth Management, Consumer Staples, Healthcare, Telecommunications and Utilities. From an individual stock point of view, Weres believes the following have been oversold: Flexigroup ((FXL)), Macquarie Communications Infrastructure ((MCG)), Macquarie Airports ((MAP)), ConnectEast ((CEU)), Australian Pipeline ((APA)), Goodman Group ((GMG)), Westfield ((WDC)) and Just Group ((JST)).
ABN Amro has had a look at large cap stocks in relation to their historical price/earnings ratios. If you accept that stocks will tend to trade within an historical PE band then you can accept that movement outside this band suggests over- or undervaluation. In some cases there are presently stocks trading more than one standard deviation below their historical mean PE.
The analysts combine this analysis with their own long term stock views to come up with a list of their preferred stocks going into 2008. When they undertook the same exercise in May, they came up with only four stocks. A lot has happened since May, and now the list numbers twelve. This list (in descending order of preference) is: Macquarie Group ((MQG)), ABC Learning ((ABS)), Babcock & Brown Infrastructure ((BBI)), News Corp ((NWS)), Goodman Fielder ((GFF)), Lend Lease ((LLC)), Perpetual ((PPT)), National Bank ((NAB)), Fairfax ((FXJ)), Boart Longyear ((BLY)), Brambles ((BXB)) and AGL Energy ((AGK)).
The first thing that strikes is that there are some names on that list currently unpopular with analysts in general, such as Goodman Fielder, Perpetual and National Bank.
The banking sector has been a big water cooler topic this year, and one that has made analysts think hard. The initial response from most analysts when the market began to correct was the hackneyed line that "banks are defensive in a crisis". This one proved about as useful as "commodity prices always revert to the mean" was about two years ago.
Eventually bank analysts started to understand more about CDOs, SIVs, and the global credit crisis, but it took a bit of share pricing trashing for it to sink in. The next common line was, however, that the big banks would not only weather the subprime storm, but would come out ahead as they drew traditional customers back from their wh*ring over in the credit securities markets. And because the big banks mostly had large deposit bases, they would not face significant funding issues.
Well this line has worn a bit thin as well, as the spread from cash to the bank borrowing rate has widened and widened. Then the analysts all woke up to the fact every major bank had provided a big line of credit to Centro, and the recommendations looked wobbly again. The analysts have largely held their ground however, suggesting the big banks still offer value for 2008. Except JP Morgan.
JP Morgan has been the black sheep of the bank analyst fraternity ever since the credit crunch began. JP Morgan analysts have held an Underweight rating for quite some time, and been pretty spot on. Aside from the recent issue of Centro exposures, JP Morgan trotted out its reasons not to buy banks once again this morning. Loan losses are at historical lows, they reiterate, and only have one way to go. Valuations are expensive when you put dividend yields up against bond yields and are expensive on global comparatives. And the steep yield curve is not about to go away in a hurry, thus eroding bank profits further in 2008.
Then there's the REIT market. GSJB Were summed it up beautifully this morning by suggesting the analysts had been "peering under rocks to see if any other Centros are hiding". It's been a tough year for a lot of analysts who have had to cope with concepts they have never before experienced. While one of the big arguments from analysts regarding REITS is that disclosure is often poor, it looks like a bit of an excuse now that factors such as Centro's 70% gearing and low quality portfolio were always glaringly obvious.
Just a tip of the hat to the equity strategists in the country who have been advising steering away from property and infrastructure trusts for a while now.
Weres has checked under the rocks, and decided considering gearing and interest cover, maturity dates and undrawn facilities, there are four trusts to steer clear of for now. They are Macquarie Countrywide ((MCW)), Macquarie DDR Trust ((MDT)), Reckson New York ((RNY)) and Tishman Speyer Office ((TSO)).
On the other side of the coin, REITS now offering good value are Westfield, GPT ((GPT)), Goodman Group and CFS Retail ((CFX)).
In a similar analysis Merrill Lynch agrees Macquarie Countrywide and DDR Trust are risky, but it is also nervous about Valad ((VPG)) and ING Industrial ((IIF)). The analysts like Goodman, Westfield and CFS as well, and throw in Stockland ((SGP)).
The last word can go to UBS. From a general perspective the strategists feel the earnings to valuation trade-off in the Australian market is now looking more attractive since recent weakness. UBS acknowledges that earnings forecasts have been coming down, and will likely fall further, but this will only be to a level which remains slightly above trend. Valuations have returned to long-run levels, UBS suggests, which means a reasonable if not exciting opportunity ahead for stocks in 2008. Funnily enough, one sector in which valuations are still above long run levels is REITS.
That kind of puts things into perspective.