More upgrades, more potential for Aussie shares

Back in early 2011, something odd was happening in the Australian share market. Equity strategists at local investment banks and stockbrokers were predicting strong gains ahead for the Australian share market, at that time nudging the 5,000 level - but instead, the index dropped towards 4,000.

What caught my attention at this time was the bullishness expressed in strategist projections and forecasts. This wasn't supported by the forecasts of analysts who covered sectors and individual companies.

As it was, those forecasts were a lot less optimistic. And as things developed, the lack of further upside as expressed through individual, bottom-up valuations and price targets proved more accurate.

The ASX200 didn't break above 5000 until early 2013; a mere two years later. I wrote a detailed analysis about it on 4 April 2011, titled How Much Upside Is There? I'm only bringing this up again today because the local share market is once again showing a similarly large gap, only this time the roles have reversed. 

Many voices are reassuring investors the share market is over-heating and poised for a retreat, but this is not what is being reflected in analysts' forecasts and valuations.

The banks' market sentiment indicator

A deeper dive into the details is needed. But first, let's catch up on my personal market sentiment indicator; the gap between share prices of Australia's Big Four banks and consensus price targets, as set by the seven stockbrokers monitored daily by FNArena.

On 15 March, I dedicated Weekly Insights to the fact Australian banks' shares were trading at or near consensus targets. Assuming my old indicator is back and can be relied upon, this should act as a warning signal - maybe market sentiment is running too hot in the short term?

In a market that is as polarised as most of us have ever seen, the ultimate question remains: does this market indicator still apply to the share market in general terms? Perhaps it now reflects this year's Value and reflation trade. Or does it now apply only to the local banking sector?

The same questions need to be asked for all indicators that can be used to gauge over-excitement and bullish exuberance. The market today is different from the market our grandfathers knew. Many calls for a sharp retreat in equity prices have remained unanswered in recent times, often to the detriment of those who retreated to the sidelines.

Since mid-March, the ASX200 has added approximately 300 points, pushing the index above 7,000. But just as importantly, the banks are trading around the same "peak" levels they were about one month ago. Except for the local sector laggard, Westpac (ASX: WBC), whose shares temporarily peaked just under $25 in March, but which have used the subsequent pullback and recovery to rally above $25.

This is typical behaviour for a sector that is pushing against a valuation ceiling. Another big question, of course, is whether the upcoming results season for the banks will deliver increased forecasts and higher valuations.

Regional lender Bank of Queensland (ASX: BOQ) has already reported. If its performance can be relied upon for three of the majors - ANZ Bank (ASX: ANZ), National Australia Bank (ASX: NAB) and Westpac - then the banks are cum further upgrades once interim performances have been released and dividend forecasts adjusted further upwards.

The consensus price target for Bank of Queensland lifted to $9.82 from $9.23 following the interim release, up 6.4%, but the shares are still trading below the near-$9.50 level from late February. Given I'm hardly inventing the wheel here, it's probably fair to assume investors are anticipating more positive news from the local banks, and this is reflected in today's share prices.

Savvy investors know forecasts and valuations (price targets) should never be treated as set in stone. One positive announcement might be enough to revive upward momentum. Of course, the same goes for a disappointing market update in the opposite direction.

Regardless, the observation stands that the Australian share market has made further gains over the month past and banks have not been the key contributor. Consider, for example, REA Group (ASX: REA) shares rallied from circa $133 to just below $160 for a gain of 20% during that time. Shares in Xero (ASX: XRO) bottomed around $105 and they are now trading above $146; a difference of 39%!

But it has not been solely about the come-back of Quality and structural growth. BHP Group (ASX: BHP) shares sold off early in March after having finally conquered the $50 mark; they subsequently bottomed at $44.50 and are now back at $47.50. Rio Tinto (ASX: RIO) shares sold off from $128.50, reversed direction at $107 and are now trading around $120.

I believe equity markets have not experienced a serious pullback because a heavily bifurcated market allowed the pendulum of short-term momentum to swing from Value and cyclicals into Growth and Quality, and back and forth on multiple occasions. Now that bond markets are laying low, at least for the time being, stocks including the following, and many others, are steadfastly narrowing the gap with consensus targets:

• Aristocrat Leisure (ASX: ALL)
• Bapcor (ASX: BAP)
• NextDC (ASX: NXT)
• Hub24 (ASX: HUB).

This might indicate that while the Banks Market Sentiment Indicator was previously mostly a reflection of the sector and this year's Value trade broadly, it might yet become a weather vane for the broader market. Maybe once we're past the interim results?

(Assuming the market doesn't segregate itself again and starts swinging the pendulum instead).

Consensus price targets: The market's second opinion

While the banks' indicator fails to provide us with a conclusive outcome, most share price targets for ASX-listed stocks are still above today's share prices, in some cases up to 60% and more. But stocks like the following can can never be treated as proxies for the broader market overall (their heavy discounts might indicate serious problems ahead): 

The FNArena stockbroker research universe of ASX listed companies consists presently of 420 entities. Of those, only 104 are trading above target, including:

• Mayne Pharma (ASX: MYX), 
• Estia Health (ASX: EHE)
• Domino's Pizza (ASX: DMP)
•  Dexus Property (ASX: DXS). 

In other words: more than 300 share prices under coverage - three-quarters of the total - still have a gap to fill.

But maybe any conclusions drawn from this observation risk being too simplistic. In Australia, the ASX20 makes up more than half of the share market in terms of index weightings, and thus more consideration needs to be given to the specific context surrounding the likes of CSL (ASX: CSL), Commonwealth Bank (ASX: CBA) and BHP.

Spoiler alert: the numbers for the Top20 in Australia look a lot less promising. FNArena's website shows all major local indices, including price targets for index constituents of the ASX20.

It's easy to establish the Top20 of Australia's large cap market leaders is split in two with half of the stocks above or very near the target, while the other half contains market laggards such as Brambles (ASX: BXB), Coles (ASX: COL) and CSL. The market enthusiasm required to push these share prices much higher over the shorter term is sadly lacking

Admittedly, Rio Tinto and Westpac are still trading below target, as are the following names:

• Goodman Group (ASX: GMG)
• Newcrest Mining (ASX: NCM) 
• Telstra (ASX: TLS),
• Woolworths (ASX: WOW)
• Woodside Petroleum (ASX: WPL).

But in many cases, just one or two days of further gains could push most of the lagging half into the upper half.

There's certainly a strong argument that the Australian share market is flirting with a lot of optimism and positive projections. The share prices of market leaders largely reflect such positivity, but it's far from an excessive bubble, as some critics would label it.

Investors should not dismiss the fact that forecasts can still increase, which would push up valuations and price targets too. 

And did I mention dividends? Many an expert remains convinced current dividend forecasts remain too low, which would only add more fuel to the anticipation of additional valuation-upside ahead.

Further upgrades may lie ahead

The Australian share market has been supported by rising forecasts for seven consecutive months, but market strategists at Macquarie, among others, still predict more upgrades lay ahead. On their estimates, forecast earnings have risen 23% from the low in August last year. Macquarie thinks earnings estimates can potentially rise another 15-20% over the year ahead.

It would make the current upgrade cycle for the Australian share market the strongest in many decades; much stronger than at any time during the Supercycle Commodity Boom. And it's not already priced in, say the strategists. They single out Woodside Petroleum, Nine Entertainment (ASX: NEC), South32 (ASX: S32), Reliance Worldwide (ASX: RWC) and Woolworths as Top100 companies for which market forecasts appear too conservative.

Equally important: if Macquarie's positive projections for the economic recovery ahead prove accurate, there remains potential for further hefty increases to current market forecasts for companies outside the Top100. This would particularly affect the cyclical parts of the market along with those sectors knocked by the pandemic, including the banks, energy companies and insurers.

In conclusion 

The Australian share market is by no means "cheap", but there is a strengthening view that current forecasts and projections are under-estimating the economic recovery that lies ahead for the second half of this year and into 2022. This implies the share market is not yet priced for perfection and should have yet more upside. 

Of course, it goes without saying that if the economic recovery flattens out or reverses, stocks priced for ongoing potential would take a big hit.

In the short term, the local Top20 can potentially run into valuation constraints, but a lot depends on the upcoming financial results from the banks. Anticipation is building. 

On the other hand, with no less than 220 stocks (of the 420) still trading at least -5% below consensus target, and more than 200 stocks -8% below and more, no one should be surprised if smaller cap opportunities become increasingly attractive to investors. 

In terms of the indicators mentioned, I believe both the banks and consensus price targets in a broad sense are signalling a lot of optimism has been priced in, but share prices remain supported by anticipation of further upgrades, which might well prove crucial for the trajectory of equities over the remainder of the year, with varying degrees of polarisation included.

The big difference between 2011 and today is that market forecasts are in support of ongoing optimism, though further upgrades will be required to keep the momentum positive.

FNArena offers unique, unbiased analysis alongside proprietary tools and applications for self-researching investors. Our service can be trialled at (VIEW LINK)

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