A near two-month rally in the sharemarket has investors nervous of a sharp pullback as the gap between earnings and valuations widens. But a small band of fund managers says the peak pessimism is a signal that things can only get better.
The S&P/ASX 200 is on track for its seventh straight weekly gain, capping a near 10 per cent rise, and as the rally has rolled on the the calls for investors to "sell in May and go away" have become louder, and from prominent voices including Bell Potter's Richard Coppleson.
While the market's very high valuation – a price-to-earnings ratio at about 16-times earnings versus its long run average of around 14 times – is running in the opposite direction to earnings growth, AMP Capital head of dynamic asset allocation Nader Naeimi says the fears are "misplaced".
Flows into exchanged traded funds showed the gap between the flows into equities versus bonds was at its most pessimistic level since the global financial crisis, Mr Naeimi said, and hedge funds were scouring the markets for the next 'Big Short'.
"Everyone's expecting a correction, everyone's talking about China's credit problems. The amount of money that's gone into bonds shows how much fear is out there," he said.
Morgan Stanley's strategy team was the latest this week to comment on the "glaring disconnect" between the high valuations of the market and the weak earnings per share [EPS] outlook.
Either earnings have to improve or share prices will fall, and the investment bank is sticking to its year-end target of 4800, expecting another 10 per cent correction on the ASX 200.
Kate Howitt, portfolio manager at Fidelity, said while some argued the valuations on the ASX looked stretched, she said they looked "OK" relative to interest rates. The US Federal Reserve's tightening cycle will also likely create "bond refugees" that will pile into bond proxies, or stocks such as real estate investment trusts and utilities, because there is no alternative.
"Even if you have rising interest rates, number one, equity dividend yields still look quite healthy relative to their reference rates and number two, you might like a high yield on your bonds but you might not be willing to go through the process to get there," she said.
While investors fretted about a lack of growth on a macroeconomic level, it can be found at a company level, she said.
Earnings are expected to pick up in 2017. A report earlier this month by Citi equity strategist Tony Brennan showed EPS growth estimate for the upcoming 2017 financial year was for 6.8 per cent growth, lifted by a recovery in resources stocks, whose EPS growth is expected to turnaround from a 53.1 per cent plunge to 14.8 per cent growth.
Mr Naeimi said while company earnings have been in a recession for a year, a lot of that had been the lagged effect of a rising US dollar and falling oil prices.
"People have seen the negative effects first. By the time we're closer to seeing the positives, people are giving up," he said. "Already we've been seeing consensus earnings expectations are trending up."
After a weak first-quarter growth, which included a disappointing inflation reading of -0.2 per cent quarter on quarter, added to investor worries, Mr Naeimi said earnings growth should support the market from the second quarter.
Stephen Cleugh, head of equities at Equity Trustees, is also optimistic. He said the extraordinary conditions in the ultra-low interest rate environment meant it made sense that the market's forward P/E ratio was elevated, and many stocks may be expensive but were still worth investing in.
"There are always opportunities presenting themselves where certain stocks will get oversold because of whatever short-term reasoning," Mr Cleugh said.
Mr Naeimi said however that the delivery of earnings growth was critical for the market to justify its current level of close to 5400 points.
"This support is really important we see earnings growth turning around. If it doesn't, valuations can't keep pushing any higher, we're going to hit a ceiling."
But with much pessimism around, it won't require much lift in earnings to lift the sentiment, he said.
