We could almost characterise our market as having a split personality.
The ASX 200 has enjoyed a strong ~30% rally from its lows around 4000 in mid-2012, but the gains haven’t been as widespread across the sectors.
A significant part of the market rally has come from the financial sector and other stocks that are known to offer high dividend yields.
In today’s editorial we will provide a background on the disparity in performance between the financial and materials sectors, and determine the potential for a reversal in their fortunes this year.
Below we graph the two year trend in the performance of the ASX200(pink line), the financial sector (green line) and the materials sector (white line).
For comparison purposes, we have indexed the returns of each of these three indices. For example, the financial sector’s 143.798 reading compares to a base value of 100 at the beginning of 2012, indicating a return of 43.8%.
We can see visually that although the ASX 200 is up approximately 25% in the past two years, the materials sector is down more than 12% during the same period.
Incredibly, there has been a more than 60% divergence between the returns of the materials and financial sectors since the start of 2012. Of course, there is a big reason behind this variance – strong earnings and dividend growth in the financial space, compared to a China-driven deterioration in operating conditions within the materials sector.
Still, it begs the question, has the divergence between the two sectors been overdone?
The P/E divergence
We are yet to see clear signs of big money rotating out of financials and into miners.
The financial sector is down approximately 4.8% since the beginning of October 2013, but the materials sector is also down around 2.3% in the same period.
What factors could help spark the rotation between the two sectors? Below we graph the 12 month forward P/Es of both these sectors since the end of 2005.
We can see that generally the two sectors’ P/E ratios have trended close to each other over the past seven years, save for three periods (circled on the chart).
We can ignore the spike in the middle section of the chart as the chaotic selling/buying during and after the GFC caused distortions in the earnings multiples of most companies.
The P/Es trended close to each from early 2010, but began diverging again at the end of 2012.
What might cause the rotation?
Recent history suggests the valuation gap between the financial and materials sector will narrow eventually.
We think this will begin to happen this year, but there needs to be a fundamental catalyst to spark the P/E convergence.
While the financials have enjoyed a huge past couple of years, the banks in particular appear fully valued after accounting for their earnings growth expectations.
The housing market enjoyed a bumper 2013, translating into stronger mortgage volumes for the big four and driving robust growth in earnings.
However the big banks have also been able to deliver cost savings and achieve significant falls in impairment charges.
The sector is likely to enjoy further solid profit growth in 2014, but share price gains will be harder to come by given the sector’s P/E expansion of the past few years.
The mining sector represents more upside potential given the sector’s low valuations (it forward P/E is just 11.6x and 13% lower than the financial sector).
The big resource plays are responding to the mining slowdown by having cut exploration and other capital expenditure over the past year.
Also, companies like Rio Tinto and Fortescue are making big inroads into reducing their debt load, strengthening their balance sheet and lower interest payments in the process.
The market is showing a tendency to reward mining companies who are focusing on cost control and improving their balance sheet.
These are trends that are expected to continue into 2014, enhancing the appeal of the big resource companies relative to the major financials.