Is a market pullback imminent?

The market is feeling very confident that profits accelerate from here, and has been very generous in looking beyond some relatively weak results for the second half of FY18-19.

Although it is probable that similar results will be unveiled at the first half of FY19/20, we believe it is still optimistic to expect a major rebound in profits given the current low growth.

There are also building headwinds such as bushfire fallout and now the disruption of a major virus scare in China, our largest trading partner, which is bound to at the very least severely disrupt the supply chain and reduce availability of goods, or at worst release a global pandemic which kills thousands of people.

The reason for this is that the fundamentals remain incredibly weak for the domestic economy, and we think that the only exception - the only area with confirmed price rises and reasonable momentum - is the property market, with residential property coming off the back of a fairly deep correction.

Despite the revival of the residential property market, economic fundamentals otherwise appear quite weak despite valuations that, beyond the resources and banking sectors, represent some of the highest in the world and sectors that are trading in some cases above their peak GFC multiples. Examples of this are supermarkets, which are trading at PE ratios of over 20, and a very expensive industrial sector.

Although valuation environment is bound to raise questions around profitability in the very near future, sentiment for now remains quite strong, almost exuberant. This combination – weak fundamentals, very high valuations and over-egged sentiment – points to the very real possibility of an imminent pullback and investors should proceed with caution.

In preparation for a pullback, investors might consider trimming exposure to Australian equities (and possibly some other risk assets) and begin to allocate more funds to cash or within the asset class to tile towards defensive sectors, such as utilities and infrastructure, where there is better cashflow-backed profitability and markets haven’t run as hard as in some of the more cyclically-exposed spaces.

Although we believe reporting season is likely to disappoint on the profit side, the momentum may yet pull markets through to a future period of brighter economic conditions. But for now we think markets have overrun slightly and are overbought on a short term basis although in time profits can and will likely pick up to justify these valuations in the long term.