Why investors should get defensive ahead of August’s reporting season

We’ve had a strong start to the 2019 financial year in terms of price movement of the share market index. We’re back to near record levels for the ASX200 after an almost 25 per cent rating upwards from December lows.

But there is a risk that those gains – or some of those gains – could be unwound during August’s reporting season if the market corrects because company profits disappoint.

Some grim realities

There are already signs that reporting season could be somewhat disappointing.
 

Firstly, while earnings per share (EPS) for the market may be flat at an aggregate index level, it is clear to us the resources sector is really driving profits. Without resources (ASX200 ex resources in the chart above) it presents a relatively weak underlying market. That’s why there are so many forms of stimulus now being applied to the domestic economy.

Secondly, we are seeing a number of downgrades coming through, particularly in the domestic-focused stocks in retail, building materials, and sectors with large discretionary spending like automobile sales. Retail and consumer companies appear to be struggling amid slowing economic growth and falling house prices.

We think the stimulus delivered to date may be able to help slow the declines and stabilise house prices, but our medium-term outlook for that market looks very challenging, particularly for highly leveraged households and companies.

Banks are also confronting a difficult outlook. Dividends are facing cuts as increasing capital requirements reduce their equity returns at the same time as rapidly falling interest rates eat into their margins.

As a result of these factors, we think the August reporting season is going to be a volatile one as lofty valuations meet the grim reality of falling profitability.

Strong mining

There are, of course, a number of strong sectors like mining, where strong $US commodity prices and weak Australian dollar (which is at a ten-year low), means margins are huge.

Some sectors like iron ore are heading back towards all-time highs due to supply issues for Brazilian miners and fresh Chinese stimulus. LNG-focussed companies also continue to enjoy high contracted LNG prices.
But, on balance, we believe the negatives outweigh the positives at this point.

What does that mean for investors?

After a strong rally we will be looking very closely and trying to be cautious as we move into reporting season for fears that profits disappoint the market after such a strong run.

As I noted recently, given this uncertainty and the potential for disappointment during the August reporting season, investors should consider choosing a robust and defensive equity portfolio.

That specifically means looking at opportunities among defensive companies with under-geared balance sheets, good cash flows and margins, and resilient business models.

If investors shift to a defensive posture, they will likely be better placed to weather any fallout come August.

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