As Professional Planner went to press in mid-January the ASX/S&P 200 Index was ping-ponging around the 6,000 points mark – a respectable enough result if you consider that the same benchmark five years ago stood at just under 3,000.

But, as with sports, it is recent performance that dominates memories and headlines and on those terms the Australian sharemarket is in a ter­rible funk.

From a high of 6754 in October 2007 the ASX/S&P 200 has slipped progressively over the following months, dropping to 6533 at the end of November and losing another 200 points during December. A further fall of almost 340 points dur­ing the first two weeks of January has brought the index over 10 per cent lower than in the heady days of October last year.

And while the decline might represent a rational market response as it digests a huge serv­ing of bad news – including such items as the US sub-prime-induced global credit crunch, a looming US recession, a shake-out in the listed property trust (LPT) sector, rising interest rates in Australia and the threat of inflation – that thought would not offer much comfort to investors watching their wealth seemingly evaporate.

For Australian equity fund managers, though, the wake-up call is one they have been expecting for some time.

As Colonial First State (CFS) notes in its December 2007 Market Watch report: “2008 is shaping up to be a difficult year.”

“Earnings downgrades will be punished as will any signs of debt financing difficulties,” it says.

“The domestic economy should underpin activ­ity but fallout from the US sub-prime issue is not going to disappear in a hurry. In fact, it’s likely to get worse before it gets better as more loan defaults emerge.”

But with the negative thoughts out of the way, the CFS analysts also offer a bit of a cheerier perspective, pointing out that while the Australian equity market might not produce returns in 2008 to match the five preceding years “it still holds the prospect of reasonable returns”.

“For the record, the total return from the ASX/S&P 300 Accumulation index was 24.5 per cent in 2006; 22.5 per cent in 2005; 27.9 per cent in 2004 and 15.0 per cent in 2003,” the CFS report says.

“These were very good years and will be dif­ficult to match.”

Indeed, the most onerous task for advisers in 2008 might be weaning their clients off expecta­tions of 20 per cent returns from Australian shares, rather than explaining the negative signs.

By any measure it has been an extraordinary five-year run for the Australian sharemarket, which has been the star performer amongst the major asset classes globally.

According to a Mercer survey released in Janu­ary, 2007 was the eighth consecutive year where Australian equity returns outpaced global shares.

“An investment of $10,000 in the Australian share market in January 2000 will now have risen to over $26,300,” the Mercer survey says.

“A comparable investment in unhedged over­seas shares would have dropped to $9000.”

Mark Daniels, head of equities at Aberdeen Asset Management in Sydney, says the strength of the Australian equities over the last few years has surprised many professional investors.

Daniels, like CFS, also predicts investors should temper their expectations for 2008 but he says the Australian market should still finish the year on a positive note.

“I’m as upbeat as you can be when interest rates are rising and the US economy is slowing down,” he says.

“We won’t see returns in the high teens and 20s again but high, single-digit returns look possible. Versus cash, equities should be in excess.”

However, he adds the proviso that the returns will come with a higher degree of volatility than Australian share investors have become accustomed to.

Long-term investors, Daniels says, should not let the turbulent conditions spook them into selling down their Australian share holdings.

Instead, he says they should be prepared to “ride out the storm”.

The rough weather could even benefit patient investors, Daniels says.

“In three or four years’ time investors may look back on this period and say it was a good time to buy selected stock,” he says.

As a bottom-up stock picker, Daniels says Aberdeen is well placed to benefit from the tougher environment as buying opportunities present them­selves. He says the fund manager has historically performed better in down markets.

Anthony Serhan, Morningstar’s head of research, also says a rough and tumble Australian sharemarket in 2008 should play to the strengths of stock pickers rather than momentum-driven managers.

Just how much further the Australian market can fall hinges on the extent of the US slowdown and “its linkages to other markets”, Serhan says.

According to Serhan, the “decoupling” theory – which says the rest of the world is now less reli­ant on the US economy – has some merit, but it remains to be seen whether Asia can sustain world growth on its own.

“We’re about to find out,” he says.

If a US recession flows on to Asia and dampens the resource boom that has largely been responsible for the gangbuster Australian sharemarket, local investors will undoubtedly suffer, Serhan says.

“It will be fascinating to see how the world economic order works this year and which fund managers come through,” Serhan says.

“We know who’s done well in similar environ­ments previously but can they do it again?”

He says 2008 should also show which hedge fund managers are worth their salt.

“Now is when a lot of hedge fund strategies make sense and they should be a stabilising force,” Serhan says.

“But the jury is still out on whether they’re worth the fees.”

Dominic McCormick, chief investment of­ficer of Select Asset Management, says the first couple of weeks of 2008 have already provided an opportunity for hedge fund managers to prove themselves.

“January will be a good test,” McCormick says.

“This is when hedge fund managers should show their value. Not all will.”

He says while hedge funds haven’t really fulfilled their promise during the short, sharp corrections equity markets have experienced in recent years, they should be more effective during a sustained period of lower returns from shares.

“Hedge funds should do a better job of preserv­ing capital or contributing to a robust portfolio in this environment,” McCormick says.

So far, the Select fund-of-hedge funds has held up well and is on track for a positive return in Janu­ary but “it’s still stressful for us”, he says.

The extent of the Australian share slump early in the year surprised even Select and he says the signs are the market is entering bear territory.

“If we are in a bear market then 20-30 per cent falls in equity prices would not be out of the ques­tion – historically those sorts of drops are normal,” McCormick says.

“In fact the last 15 years have been abnormal in that we haven’t had falls of that magnitude. If that happens, how many investors are in a position to wear it?”

Tim Farrelly, head of asset allocation specialist firm Farrellys, is also downbeat about the prospects for Australian equities.

According to Farrelly, for the first time in decades Australian shares are looking expensive compared to other markets.

“The value differential between Australian shares and international markets hasn’t been this significant for 30 or 40 years,” he says.

For example, as at the beginning of January 2008, Farrelly says the average Australian industrial shares P/E ratio stood at 17.5 compared to 12.5 in the UK market. Against every major market Far­relly has measured, Australian shares are looking over-priced.

“Australian shares have been cheap for some time. They’re not cheap anymore,” Farrelly says.

Even the 10 per cent slump in the Australian equity market since October has not altered his view.

“To me that [10 per cent fall] is not enough,” Farrelly says.

“If you’re planning on investing money this year look overseas.”

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