By far the biggest theme in Australian equities over the past few years was the dominance of the total returns that the aggregate of the four high-yield sectors (financials-x-REITS, REITS, telcos and utilities, known as the ‘yield-play’) over the aggregate of the other seven sectors for an extended period – and then its swift demise in 2016.
Indeed, for five successive years (2011–15) – as I showed in the Oct ’16 issue of Professional Planner – the yield-play dominated the ‘others’, after mixed results for the previous eight years. Last year brought a reversal of fortunes for these two highly aggregated sectors – after quite a good start to 2016 for yield. From Chart 1, it can be seen how much their fortunes have oscillated in recent times.
Identifying regime changes such as these is very difficult. Interested readers might care to peruse our contributions in the May ’14, Sep ’14, Feb ’15, Jul ’15 and Oct ’16 editions of this publication to see how our thinking and calls evolved in real time on this subject.
I personally rebalanced away from my 100 per cent high-yield tilt at the start of last October to a 100 per cent high-conviction tilt. It turns out that I was a month or so late in rebalancing. But the cost of having left the rebalancing even longer would have been disastrous – leading to a serious underperformance of my fund to the tune of around 9 per cent in only four months!
But all was looking good going into the US presidential election with my new portfolio. The materials’ sector has had a great run, which is still going at the time of writing. Financials were looking really cheap in mid-October by our measure of exuberance or mispricing. Indeed,
our measure put that sector as being cheap by 5.4 per cent.
At that time, there were general concerns about possible regulation changes for banking here and overseas. But Trump swept all of that away and financials again became the toast of the town.
The trouble is, that sector in Australia got overcooked. It became +6 per cent overpriced – the trigger for a correction or prolonged sideways movement – on December 20. The problem we faced at home was whether our ‘system’ would change post-Trump to make the mispricing measure temporarily out of date.
The US financials’ sector was even more heavily overpriced – and it still is. However, the US is facing probable rising interest rates and big changes in regulation. We, at best, are looking at flat rates and no substantive changes in regulation. As we can note from the ‘heat-spot map’ in Chart 2, which is an update of the same chart (and for the same reason) in the Jul ’15 issue, we got ahead of ourselves and so the bubble burst. The red spots show the ‘danger’ region for corrections (> +6 per cent) and we got one – a big one – as we had six times before in the years since the start of the GFC recovery.
Much of the overpricing in financials at home has now been flushed out of the system – but that it is not the case in the US, as it is still +10 per cent overpriced by our measure. A number of the big US banks just shot the lights out in their recent reporting season. Their overpricing seems set to be eroded slowly, and in an orderly fashion, as earnings forecasts are revised upwards to match the Trump-era expectations.
So what does that mean for Australia? It looks like the return of the yield-play in late 2016 has come and gone. For those of us who rode that wave, it might be time to think of going back to a more conventional high-conviction portfolio that better balances the yield-play and ‘other’. We are currently forecasting just under 8 per cent for the capital gains for each of the two aggregated sectors over the next 12 months. Expected yield is 5.8 per cent for the yield play and 3.1 per cent for other.
With similar expected capital gains – but a higher yield in ‘high-yield’ – a skew to yield is warranted but not to the extent that it was in
years gone by. A high-conviction portfolio, in my opinion, has a strong exposure to both of these aggregated sectors.
