The next bull market is underway

Market lows are never obvious at the time but we suspect equity markets have begun a sustainable recovery. 

Here are four reasons why the worst is behind us.  

1) Post a bear market two positive quarters signal the start of a bull market

In the US, the end of the last three major bear markets have been followed by two consecutive S&P 500 index quarterly gains. The S&P 500 has just delivered exactly that result with the December quarter 2022 up +7.1%, and the March quarter of 2023 up +7.5% following its bear market correction over the first nine months of calendar year 2022 - when the index fell -25%. The US equity market historically leads the Australian market, and we see the recent performance of the S&P 500 as being a positive lead indicator for the Australian equity market outlook, which itself started 2023 with a positive first quarter.

2) Valuations – Australian equities are cheap

The S&P/ASX 200 index which tracks the performance of Australia’s largest 200 companies, is now trading on a 12-month forward price-to-earnings (PE) multiple of 14.1x, versus its five-year average of 16.4x - a discount of 14%. Small companies are even cheaper, with the S&P/ASX Small Ordinaries index trading on a 12-month forward PE multiple of 12.3x.

Even more interesting is that the small company sector is trading well below its long-term PE average vs large companies. Specifically, since its highs in 2021, the small company sector has fallen from a 5% premium to a 13% discount compared to the large company sector. If you believe, as we do, that small companies have a greater potential for growth than their more established large companies peers, then opportunity exists.  

As a result, we see a potential opportunity for small companies to outperform as risk capital returns to the sector over the next year.   

3) Central Banks are almost done which will be positive for equity markets

While the economic cycle should not be ignored, the interest rate cycle plays an important role in determining equity valuations. The lag effects of the announced interest rate increases in the last year will drag on the economy for some time but we expect markets, which are forward looking, to rally as interest rates approach a cyclical peak.

Interest rate changes act as lead indicators for markets pricing future equity returns. US interest rates have increased from zero to 4.75% in the last year.  We expect markets to rally ahead of the 'good news' associated with a peak in the current central bank interest rate cycle.

The RBA delivered its first-rate hike in May 2022. The RBA has now increased interest rates 10 times and the cash rate has moved from 0.10% to 3.6% during that period. At its recent April meeting, the RBA elected to pause the rate hiking cycle. The chart below outlines the Cash Rate history since 1990.  

It would seem that central banks are getting to the end of the current rate increasing cycle as economies slow and inflation declines. While global inflation is still higher than most central banks would like, it now appears clear that inflation is declining from its recent peaks. In addition, other macro indicators such as unemployment, gross domestic product, and retail sales all point to a slowing economy, taking the pressure off future interest rate increases.

4) Sentiment is Bearish – historically the right time to buy

History has taught us that a non-consensus view normally delivers long-term outperformance. We believe the extreme defensive positioning within the market combined with the strong bearish sentiment regarding the outlook equity valuations provides an ideal opportunity to take a non-consensus position.

Investors remain bearish. Cash levels in both the institutional and retail sectors are above average. According to global asset management industry body, Investment Company Institute, money market funds currently have cash holdings in excess of the peak achieved in the earlier months of Covid-19 sell off in 2020. Negative commentary regarding the cost of living and the outlook for the economy has moved from the financial sector to the broader community. Not many days pass without a front-page news story describing the challenges being experienced by the consumer. As a result, consumer sentiment is down, and interestingly, lower than it was during the Global Financial Crisis.  

In Australia, equity managers are defensively positioned. Institutional exposure to defensive holdings has consistently increased since March 2020 and continues to rise. Portfolios are overweight defensive exposures such as telcos and supermarkets and underweight two of the largest growth sectors in the market, financials and materials.  

We believe IT'S Time to Buy equities.

The March quarter delivered several unexpected shocks which included the closure of Silicon Valley Bank in the US and the forced acquisition of Credit Suisse by UBS. It was a volatile ride for equity investors. Despite the challenging news flow, global indices finished in positive territory and have been remarkably resilient, despite the uncertainty associated with the global banking sector and the tightening credit environment. The S&P 500 index in the US did not drop below its December low in the March quarter, a good sign for the rest of this year.

With a number of factors suggesting to us the next bull market has already begun, we believe it is time to add equity exposure to the portfolio.  

The Centennial investment team - Matthew Kidman, Gary Joffe & Michael Carmody.

Want to know more?

Matthew Kidman is a Portfolio Manager for the Level 18 Fund. If you would like more information, it is available via the Centennial Asset Management website.