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What will stop the market returning to its highs?

The worst seems to be over. Road traffic is returning, retail sales are rising and house auction clearance rates have improved. In the US, air travel and hotel and restaurant bookings have bounced. Economies around the globe are cautiously and tentatively making the necessary steps towards recovery. Many sectors of the economy are not getting worse and some are growing quickly.

Meanwhile, markets are buoyed by optimism surrounding the reopening of commerce and the growing number of experimental vaccines under development.

Heading for a common destination

The post-pandemic news flow is so good that I am reminded of one of those trains in India, where upon every vacant centimetre there is a human desperate to travel to their intended destination. Crowded trains and crowded trades, it seems, are both part of the human need to go in the same direction.

Even as we talk of post-COVID-19 conditions, we are not yet certain the pandemic is under control. Developing and developed countries weigh the easing of lockdown restrictions even while new coronavirus infections and deaths rise. Meanwhile, the optimism about a still ‘hoped-for’ vaccine ignores the time it will take to manufacture billions of doses and the logistics required to disseminate it to everyone on Earth.

As borders are opened and restrictions eased, the risk of an explosive acceleration in infections, hospitalisations and deaths remains and so a measured approach to the reopening of businesses and economic activity is certain, as is the breaching of health and social distancing guidelines and requirements to keep populations safe.

But no matter, it seems. Investment markets don’t need the problems to be solved and concluded, they merely need the worst to be behind them. The recent strength in equity markets reflects an optimistic future.

Has it gone too far, too soon?

The recent rally and sustained recovery in share prices have expanded the price to earnings (PE) ratio for the ASX300 to 18 times earnings. While PE ratios aren’t always a reliable gauge as to value, in aggregate they can be helpful in establishing whether sentiment is dominated by enthusiasm and optimism, or pessimism and hopelessness.

Figure 1 reveals sentiment in the Australian market is almost as optimistic as it has ever been (recalling PE ratios at the end of calendar 2019 were the highest on record).

Figure 1. ASX300 PE v EPS

Source: Andreas Lundberg at Montgomery Investment Management using Bloomberg.

Notwithstanding the fact that a multitude of companies have pulled their guidance for FY20 and FY21, consensus earnings have plunged and multiples have returned to levels seen at the peak of the prior boom. Obviously, if earnings expectations recover materially in the near future, the forward PE ratio will contract, all else being equal.

At the time of writing, the ASX small companies index is trading at 21.4 times earnings for the next 12 months and 20.9 times FY21 earnings. Consensus earnings estimates suggest aggregate earnings will exceed 2019 levels in FY22.

Signs of better company results

Supporting this view is a litany of positive updates from Australian companies.

In the automotive parts and supplies sector, Eclipx has noted that the volume of end-of-lease car sales is picking up; Bapcor is optimistic; and even Mercedes is reporting a pick-up in sales off depressed levels. Other operators are also recording a recovery in used car prices, a clear sign consumers are spending.

With consumption a significant proportion of economic activity and output, it’s worth considering the recent aggregate consumption data.

Even back in March 2020, total retail sales were up 10.1% year-on-year and 8.5% higher month-on-month. The significant year-on-year jump was due to stockpiling and panic-buying of liquor (+33.9%), pharmacy items (+29.4%), and groceries (+26.7%), ahead of expected lockdowns. And anyone lining up at Bunnings for ‘essential’ items during the lockdown would not be surprised to also learn the Hardware category saw retail sales up nearly 18% year-on-year, while recreational goods were up 16.7%.

Retailers from Baby Bunting and Adairs to Kogan and City Chic are reporting accelerating year-to-date sales, a jump in online business (Kogan reported a more than doubling of April gross sales) and success in renegotiating cheaper leases and therefore a lowering of the cost of doing business.

Another measure of consumer activity is provided by the operators of consumer fintech solutions and platforms. Buy-now, pay-later operator Afterpay reported the online share of total retailing accelerated 10% in April, up sharply from 6% in February, while competitors Zip Pay and Flexigroup reported flat arrears and resilient volumes respectively. The UBS Consumer Survey recently indicated spending intentions are better than previously feared.

Housing, and in particular residential construction, is one area we have held concerns. The residential construction industry employs about 3.5% of the Australian workforce (representing a lot of potential retail consumers). Our channel checks had reported a near one-third drop in forward orders for new builds thanks to pressure on household incomes, contract cancellations, a forecast 30% drop in net overseas migration this financial year and an 85% fall in 2020/21. This would potentially have serious consequences for the likes of Stockland, Mirvac, Adelaide Brighton, Boral and CSR.

Most recently, however, the Prime Minister announced a package that would ensure support for the beleaguered sector.

We need to define 'recovery'

The question of course is whether optimism over a V-shaped recovery is warranted. It is true that we are witnessing a recovery from the impact of lockdowns. But what is the definition of a recovery? If recovery means a bounce from the bottom, then we are in a recovery.

But if the definition of recovery is a return to pre-crisis levels of demand, revenue and profits we are a long way off. Indeed, expectations of a rapid return to pre-crisis levels of activity look like wishful thinking.

Take restaurant bookings for example. According to Steve Hafner, the chief executive of OpenTable in the US, despite a slow and steady rise in seated-dining bookings across the US, as many as a quarter of restaurants in the US will never open their doors again.

In Australia, with unemployment a lot worse than the full-employment levels we enjoyed prior to February, restaurants can expect the same tentative recovery.

Meanwhile, the retail sector in Australia is unlikely to return, in aggregate, to the levels enjoyed previously. Retail is the second largest employer in Australia. With a plethora of household name retailers having collapsed or closing a significant number of stores (McWilliam’s Wines, Flight Centre, G-Star, EB Games, Bardot, Curious Planet, Jeanswest, Bose, Kaufland, Colette, Ishka and kikki.K) it is reasonable to expect that fewer jobs will be available for JobKeeper recipients to return to when their payments cease.

With market valuations at stretched, if not extreme, levels, the question investors must ask is whether the current buoyant recovery is more than a little fuelled by government support.

There is little doubt that it will take very little time for the economy and business activity to show a recovery from the lows, but it will take much longer to fully recover. And the time and sustainability of a recovery is very much dependent on the willingness of government to offer support. By September or October this year we will have a much better idea of the extent to which the recovery is self-sustaining. That is when many of the current support offerings by government, banks and landlords expire.

In the absence of government support, we believe household incomes would come under significant pressure by the end of the year. Combined with still record levels of household debt, it is a recipe suggesting too much optimism is  currently reflected in the equity market.


Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.


June 03, 2020

No one has mentioned algorithmic or high frequency trading which is most likely behind this "recovery". The systems have been provided limits and they trade within them which may spur a price rise which triggers the next guy to activate his limit and so on. ASIC had to apply algo brakes in March to help stop the fall. But no one mentions anything about how it many be fuelling the rise... because who cares when things are going up?

May 31, 2020

Loved reading the comments ...

Roy Taylor
May 31, 2020

I am close to 80 and I have always been on the optimistic side , it is better for your health better for everyone I have been trading stocks more since march than any time in since the GFC , life get better every decade to many dwell in the past wake up look to the future cutting your through is a bad option get out there head down butt up were all going to kick the bucket one day so why be worried get some positive thoughts and enjoy life we only get one shot.

June 02, 2020

Hi Roy,
I like your positivity, I’ve been trading stocks and I’m looking for mentor or at least someone to share experience and ideas about share trading, if you are interested, please don’t hesitate to shoot me an email.

May 28, 2020

All the talk is on growing the economy by increasing the efficiency of labour. This is dramatically achieved through on-line purchasing. While this initially increases unemployment, in the long term it increases our standard of living by reducing the cost of goods sold.

David M
May 28, 2020

The depression in retail and hospitality is not just driven by the business owners. One factor that will confirm this is that people - particularly older people - are reluctant to go out to shops and cafes/restaurants. This caution is not going to go away soon despite politicians caving in to interests who want to remove restrictions.

Another is that people have found that they can have a good time without having to go out and spend money. It is likely that this will continue for some time.

May 28, 2020

A pessimist is what an optimist calls a realist.

June 10, 2020

It also works the other way Warren "An optimist is what a pessimist calls a realist"

May 27, 2020

Clearly under weight Roger! How about we get real - every model for Covid has been dire and every model has been wrong. "Chicken and Egg" because the predictions were dire, the world shut down and it was not as bad as expected

Locally Treasury predict Armageddon, only a $60B over estimate of the damage [refreshing as they normally under estimate!] but reality is that Australian damage is far less than expected and the Banks popped as the lights went on! The world is moving from "terrified by Covid" to "living with Covid" and the bears are getting very chilly on the sidelines..

Of course you cannot discount a return to March 23rd however as economies re awaken, the sidelines might seem very lonely

David M
May 28, 2020

No-one is going to win a prize for under-estimating the severity of a pandemic. The cost is exponential growth of cases and extreme lockdown measures that last for a long time.

Much better to take the precautions initially, and if it turns out to not be as severe as first thought, ease off the restrictions more quickly.

Criticising the modelling for pandemics is a bit hypocritical. How do you model an unknown with no previous data?

otoh, economists have decades of data to work with, and how often are their models correct? Yes....

Dennis A
May 29, 2020

USA, UK, Russia, Brazil not as bad as expected? 100,000+ deaths in America, how much worse did you expect that to be?? The reason it wasn't bad in Australia is because Governments locked down to control the spread. Otherwise it would have been bad, that is obvious looking at the experiences of those other countries.
Sweden didn't lock down, only "advise" yet they had a large number of deaths, over 4,000 in a small country.
Alarmingly 11.9% of confirmed covid-19 cases in sweden died. That is appalling. And their economy has fared very badly into the bargain.
Roger is right. To all those "bulls" out there wait until reporting season. In normal times when a company reports reduced earnings or disappoints the market the share price gets smashed. Watch what happens during the next round. Many companies will reduce or suspend dividends just as the banks have done.
It would be more fitting to predict the share market will be a train wreck come reporting season.
What amuses me about the criticisms of Governments in Australia locking down too hard is the fact that if they hadn't, as in the USA etc, most likely the same critics would have been saying we didn't go hard enough.
The reason the modelling was wrong in Australia is BECAUSE we locked down.

May 30, 2020

I support "The reason the modelling was wrong in Australia is BECAUSE we locked down."

Just like Y2K, it wasn't an issue because actions were taken to fix the bug!

May 30, 2020

I suppose you think that the response to the GFC was overegged too.

May 31, 2020

The aim of the lockdown was to flatten the curve - to not overwhelm the medical system. So whilst they had 90,000 beds available the maximum used was less than 500. Meanwhile cancer rates etc are going up because of no elective surgery for that period of time. Not to mention suicides, anxiety, depression and relapse of drug addicts/alcoholics. The riots in the US are symptomatic of the national stressors of lockdown and economics. Meanwhile, on planet earth, about 5million people die per month from all causes - so for this year approximately 1.5% of them are due to covid. Over 250,000 Americans died of the flu last flu season - more than double their covid. "Ahh, but the rate is low because of the lockdown" some say. Ok, let's look at the cruise ships - if you have been on one you will know it is almost the best way to pass on virus to a population - yet the infection rate was less than 20% with mortality being about 1% of those on board and about 80% of the passengers being asymptomatic. And from US/China studies, about 8% of mortalities have no known co morbidities - the rest are either diabetic, or have cardio or lung issues.
The moral of the story is - we should shut down planet earth every flu season - and ban smoking - and ban driving - if we truly care.

Graham Hand
May 31, 2020

I will not fact-check everything in this comment but the number of Americans dying from the flu each year is nowhere near 250,000. You cannot make up stats to suit the argument. Less than 50,000.

"From October 2018 to May 2019 the FluSurv-NET data accounted for about 7,000 influenza-associated deaths, which CDC ultimately used to estimate 34,200 total deaths for the 2018-2019 flu season."

May 27, 2020

The speed of the recovery has matched speed of the decline. Usually shares are 6-12 months forward looking I think that is now stretched to 2 years. However if we continue to squash the curve and the borders open soon there is much to be optimistic about. At the moment our leaders namely Premiers are not appreciative the economic damage done by closed borders.

May 27, 2020

I'm one of the optimistic ones, which puts me in a minority (especially among Firstlinks readers). Us humans are pretty darn good at adapting and finding ways to continue growing, developing, improving, building, and generally creating the kind of life that we decide we want. It's what we've always done.
(Optimists also tend to be happier and healthier, and have stronger immune systems :P )

May 27, 2020

I can hardly believe the amount of optimism around at the moment.
What happens come September/October when public largess is withdrawn and the banks restart mortgage and loan repayments. A double whammy hit all at once, that is when we will see if the emperor is naked or not.

May 28, 2020

Stefy, spot on! This optimism is just crazy. Our economy was dead BEFORE the virus. It's double dead now. Still, you got to love those lemmings. They provide all the best opportunities.

Gary M
May 27, 2020

Until FOMO is removed by a second wave or a harsh dose of economic reality, this market will keep running.


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