Where to invest in 2008

As the sharemarket moves into bear territory, shares are looking like a very risky investment, but the Australian economy is not all doom and gloom – yet. JAMES DUNN delves into where 2008’s brighter investment options should surface.

By James Dunn

We’ve all seen the graphs – the sharemarket has a bear’s claw in its back. Where, then, are the investment havens?

Well before the Australian sharemarket’s 25% summer crash, there were already plenty of concerns as to whether it could continue on its record streak.

After returns of 27.9% (2004), 22.5% (2005), 24.2% (2006) and 19.3% (2007), the sharemarket was projected to deliver a lower return in 2008, of about 12%.

But with the market down 15% for the year already – and down more than 20% from its November 2007 peak – that target looks a long way away.

“If we end up with just the dividend yield from the sharemarket, about 5% to 6% with franking, that would be a good result,” says Brian Parker, chief economist at MLC Investment Management. “Anything higher, any contribution from growth at all, would be wonderful; but don’t bank on it.”

The best way for share investors to view 2008, says Parker, is as a year to “batten down the hatches”. “With the sharemarket down 20%, there’s not much point in baling out of your shares allocation. You’ve just got to stick to your long-term financial strategy.”

Parker says the best returns in 2008 will “probably come from cash”, which he expects to earn about 7%. “The return from Australian dollar cash has not beaten the return from shares since 1994, but that’s what can happen in a year where all the valuation excesses of the share boom are unwound.”

Michael Knox, chief economist at broking firm ABN AMRO Morgans, says that “fair value” for the S&P/ASX200 index – based on current earnings per share numbers and bond yields – stands at 6347 points, or about where the market began the year. He expects the market to return to fair value “by the time we reach the second half of calendar 2008”.

Knox says the market fell so suddenly because most of the downward revision in US earnings expectations has occurred in the last four weeks. “Over the last two quarters of 2007, US companies’ operating earnings declined by an estimated 21%. The reality of the slowdown in the US economy in the fourth quarter has caught up with analysts’ expectations. Anyone glancing at the path of earnings downgrades would think of three things; recession, recession and recession.”

Knox says the sharp fall in the US sharemarket – which is down by 16.4% since October – is a rational response to this decline. But the US fall has generated a similar decline in Australian share prices – which is not rational in the Australian context.

“US earnings are falling, but Australian earnings are growing,” he says. “We expect Australian companies’ operating earnings to grow by some 15% in calendar 2008. Our fundamentals are much better than theirs.”

Craig James, chief economist at CommSec, says that because investors have not been focusing on fundamentals, the local sharemarket has been hammered. “The causes of the economic slowdown in the US in 2007/08 are very US-specific – a function of a housing market boom/bust.

“There would be reason to be worried if our economy was weak and our companies were experiencing lower sales and earnings. But that is far from the case. The Australian economy is in the best shape possible to weather the current sharemarket storm. In fact, judging from the latest inflation figures, our economy is probably going too well.”

Whether the US experiences a recession in 2008 is “touch and go”, says James, because of the severity of the housing correction. “Much will depend on the US consumer, who accounts for around 70% of GDP. But the Australian economy has certainly started 2008 much where it left off in 2007 – full of running. And Australia is more tapped into the Chinese economy than the US. We still think China will grow this year. It might not be the 11.5% growth rate that people expected, but it should still be 10%.”

James is looking for a return of 5% to 10% from the sharemarket in 2008. “I don’t think people would be too disappointed with that. If you work on the principle that returns on the sharemarket average about 13% to 15% a year over the long term, you can’t go too far wrong. But over the past five years, investors have enjoyed super-normal returns, averaging just over 22% a year. “Something had to give,” James says.

“But if you look at the brighter side of the correction, it has given investors the cheapest share valuations for 17 years. There are some very good bargains among the top-quality shares, which have all been thrown out with the bathwater. Companies with US earnings, companies with high debt levels, have all been pounded. But it’s been indiscriminate selling.

“The volatility that we’ve seen this week – down 7% one day, up 6% the next – is pretty nerve-wracking; but when the dust settles, people will realise that the best stocks have very sound fundamentals. We expect the earnings season coming up to re-focus people’s minds on the fundamentals.”

James expects asset classes such as infrastructure and non-residential property – particularly office property – to top the performance tables this year. But he adds that exposure to these should be sought through direct, or at least unlisted, vehicles – to avoid the volatility of the sharemarket.

There is also the rider, he says, that if the Reserve Bank raises interest rates again – which CommSec believes will happen in February, because of inflation pushing above the bank’s target band of 2% to 3% – any potential wholesale migration to property by investors will be nipped in the bud.