NEWS + VIEWS – 31/01/2025
MARKETS
So far this year, share markets have been positive both offshore and domestically. In Australia, annual trimmed mean inflation fell to 3.2% in December from 3.6% in September, which is still outside the Reserve Bank’s (RBA) target range of 2 to 3%. Markets have priced in a February interest rate cut. The RBA will not wait until the range is reached but is likely to react if it feels confident that the range can be reached in future quarters. The decision from the RBA will remain politically fraught.
Chinese AI company DeepSeek caused ructions in US technology markets when it released its latest version last week. There appeared to be a bit of shoot now and ask questions later as far as share prices were concerned. However, there is a bit to play out:
How much cheaper would the DeepSeek model be for end users?
Will it reduce the future demand for chips and energy used by AI data centres?
Has DeepSeek contravened intellectual property laws?
What are the security implications for Western users? DeepSeek makes no claim that it will keep data private.
One thing to note is how fast moving the AI area has become as well as the acute competition, which at least should be good for end users.
BULL MARKETS
The chart below estimates that current Price/Earnings ratios in US share markets are well above the historical median. Markets are betting that company earnings will continue to grow sufficiently to bring down the ratio (i.e. if Earnings (‘E’) rises and Price (‘P’) is constant, then P/E falls).
Another way of looking at P/E as an indicator of how expensive share prices are is that P/E expresses the number of years a company will take to pay off the investment from earnings (e.g. a P/E of 28 suggests that Nasdaq companies will take 28 years to pay off the share purchased at today’s prices). However, investors are expecting earnings to rise. If they rise 15% next year, theoretically P/E would fall to 24.3. If earnings rose another 15% the following year, the P/E would be 21.1 times. Of course, that assumes that ‘P’ does not change.
A 15% or even a 20% earnings rise is not unusual for growth companies. For example, Amazon’s 4th quarter growth has been estimated to come in at more than 40% on the same quarter the year before. Nvidia in 2024 reported a 123% rise in 2023 but in an example of ‘be cautious around optimistic projections’, the DeepSeek announcement put the skids under the share price on Monday. Nevertheless, by Wednesday it had started to recover.
US shareholders are betting on earnings to maintain high growth rates. That is probably a reasonable assumption particularly given the expected interest rate cuts. However, growth is finite and at some stage earnings will disappoint. When? That is the question.
The chart below shows the current bull market at 67 months long is moving into the range of longer dated bull markets. It is around 50% of the way to matching the bull markets ending in 1987 and 2008. Both of those bull markets did not end well so we would prefer not to replicate those patterns. US markets are currently in the range of the next ‘batch’ of longest bull markets, which would suggest some degree of caution is appropriate.
Source: Real Investment Advice and the Coppo Report
Unlike Australia, the US is going through a productivity boom that in turn is flowing through to company earnings. While US valuations appear to be elevated, the market is increasingly biased to high growth sectors such as Technology. Assuming the absence of a geopolitical, economic or earnings shock, we expect that US share markets will continue to deliver good returns in the short term. Nevertheless, we do not expect that the high returns experienced by US company shareholders over the past two years will put a ceiling on shareholder returns over the medium term. At the same time, high valuations do make markets more susceptible to unexpected trends and events (e.g. the DeepSeek announcement).
Domestically, the big movers over the last year with high P/E valuations are the banks. Other sectors have not exhibited the same valuation expansions. In a reaction to the rapid rise in bank valuations, large fund manager Australian Foundation Investment Compnay (AFIC) has trimmed their investment in Commonwealth Bank (CBA) - but is still its largest holding - and reinvested the funds into Sigma Healthcare (SIG), BlueScope Steel (BLS) and Worley (WOR).
Gerard O’Shaughnessy
P 0423 771 330
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