There have been rumblings over emerging markets and the slide in currencies like the Turkish Lira and South African Rand.
And if that weren’t enough, investors came in for a rude shock last week when data revealed a huge slowdown in American manufacturing activity during January.
Just how significant are these concerns over emerging markets and the US manufacturing sector? We indicated last week that the flare up in the Turkish Lira was just that, a flare up.
Also, the magnitude of the slide in US manufacturing suggests the data was an outlier, likely influenced by the unusually harsh American winter.
In today’s editorial we will apply a theory known as the ‘Fed Model’ to determine whether value is creeping back into the Aussie market following the recent sell-down.
We then look at the big four banks and assess whether their recent share price pullback represents a buying opportunity.
The Fed Model
There are different ways to measure sharemarket value. One theory of equity valuation used in the investment community is known as the ‘Fed Model’.
It is a basic concept, which compares the yield of a 10-yeargovernment bond to the forward earnings yield of the sharemarket.
The sharemarket earnings yield is simply an inverse P/E ratio – earnings per share divided by price (E/P), instead of price divided by earnings per share (P/E).
The Fed Model says that when the earnings yield of the market is greater than the yield of a 10 year government, there is value in the market. The greater the difference between the two yields, the greater the value in the sharemarket.
After all, the higher the difference between the return (yield) of two assets, the more investors would prefer to invest in the asset with the greater return (yield).
Below we chart the 12-month difference between the ASX 200’s forward earnings yield and the 10-year Australian government bond yield (blue line, with the percentage difference on the left-hand side of the chart), overlaid with the ASX 200 Index (red line, with values at the right hand side of the chart).
As we can see, after mostly trending down over the previous six months the blue line has begun ticking higher in recent weeks (highlighted on the chart) – the market’s earnings yield is increasing above the Australian 10-year government bond yield.
We can see the red line, being the ASX 200, has yet to turn higher – investors haven’t begun flooding back to the Aussie market despite it offering the best value since last August according to the Fed Model.
There doesn’t appear to be anything too sinister about this recent market pullback. If there were, earnings expectations for Australian companies would also have been revised significantly downwards.
The ‘E’ in the E/P earnings yield would fall alongside the ‘P’ and the overall result would be the blue line ticking lower, instead of ticking higher like it has been recently.
Banking on dividend yields
The big banks have enjoyed a big rally over the past two years, and on a P/E basis they are not as cheap as they once were.
Their share prices have taken a pounding over the past few months as global markets in general adjust to the US Federal Reserve withdrawing its stimulus program.
The pullback in the big banks has more to do with the deterioration in global market sentiment rather than any sector specific issues.
As we head into the Australian reporting season, investor focus is likely to shift back to earnings and dividends.
Earnings and dividend expectations for the big banks haven’t really changed despite the recent market losses.
Instead, the pullback has improved the valuation of the big banks. Below we chart the trend in the 12-month forward P/E ratios of the big four, as well as their dividend yields.
As we can see from the top panel, the dividend yields of the big banks have been trending higher in the last two months (circled section on the chart).
All four big banks’ dividend yields are now over 5%, with NAB (6.16%) and Westpac (5.96%) offering the best yields among the group.
The bottom panel shows the P/E ratios of the big four banks, and all of them are now trading on multiples of below 15x (circled section on the chart).
ANZ (11.7x) and NAB (12x) are the two banks with the lowest P/E ratios, yet even CBA, which traditionally trades at a premium to its rivals, is offering value at a P/E of 14.3x.
Putting it together
Having applied the Fed model to the ASX 200, it appears the Aussie market is offering the best value since last August.
Also, an analysis of the P/E ratios and dividend yields of the big four banks suggest there is value to be found in that space.
This isn’t to say the market and indeed the banks won’t continue to experience bouts of volatility. However, the severity of the recent pullback has presented a buying opportunity in our view.