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Equity returns on a go-slow in 2007

07 December 2007 Gareth Stokes

They say that the past is never a good indicator of the future. Nowhere is this truer than in the world of stock market investing. We sit through many presentations each year – and without exception graphs featuring price data going back one, three, five

In some instances they provide fantastic illustrations. Nothing gives the portfolio manager a greater sense of security than a 100-year graph of an all share index that confirms an annual average return from equities in the 17% to 18% bracket. And an overview of recent trends and events over a five year period can prove helpful in predicting how markets will react to certain economic conditions.

But there comes a time when no matter how rosy the situation reflected in these graphs and charts, economic factors override and dictate a more cautions approach. Judging by comments at the latest Sanlam media briefing, South Africa is entering such a period. So it neither matters that a three-year graph of the all share index has a 45-degree upward slope nor that emerging markets outperform developed ones by a huge margin in 2007.

Moderate your expectations – 2008 will bring lower equity returns

Instead what matters is that domestic price inflation and a high interest rate environment are likely to cut back on corporate earnings in the coming year. How much this will impact on equity returns is anyone’s guess. Alwyn van der Merwe, director of investments at Sanlam Private Investments presented an interesting equity return matrix to support his answer to this question.

Projecting forward one year, the matrix compared expected earnings per share (EPS) growth and the expected 2008 year-end 2008 price-to-earnings (PE) ratio. Van der Merwe expects 2008 EPS growth to be in the 15% to 20% range. This is significantly lower than earnings growth reported in the last three years – with South Africa’s top listed companies regularly reporting EPS growth in excess of 30%. The exit PE is expected to come in at between 14 and 14.5 times. This is slightly lower than the market’s PE of around 15 at present.

Given these inputs – Van der Merwe estimates returns from equities (excluding dividends) of between 4% and 12% for 2008. And that is significantly different to what local investors have become accustomed to. The JSE All Share Index rewarded investors with 42.7% in 2005, 32.6% in 2006 and should close around 20% higher in 2007.

Resources boom should hold out

The commodities boom which has buoyed domestic markets in the last few years appears intact. However, a look at real metals prices (going back to 1960) may provide cause for concern. Real metals prices are 3.5 times higher than three years ago. And history shows these prices come crashing down quicker than they rise. Despite this concern investors who remain in equities will probably still want some exposure to resource and commodity stocks.

What metals should investors choose? There are some early signs that the commodity market focus could move away from base metals (like copper and iron) to precious metals – platinum and gold in particular. Investing in gold mining shares is a risky business with many global factors impacting on the gold price and the resulting investment return. And South African gold mining operations have been in the doldrums for a number of years. The problem is not with the gold price (which is up from around R140 000 an ounce to R170 000 an ounce), but rather with the mines’ inabilities to maintain production levels and contain costs.

Platinum is a simpler market to understand. The platinum price is more attuned to the supply demand equation than gold can ever be. As an example, the price of platinum jumped after a recent day-long mineworker strike which caused Impala Platinum to predict a drop in production of 3 500 ounces. The platinum price is supported by industry demand for platinum (and other platinum group metals) for use in the motor vehicle industry, particularly in catalytic converters.

Waiting for the interest rate cycle to top

Earlier this year we carried comment from economists who felt the interest rate cycle would top at 13.5%. They subsequently retreated, saying 14% would definitely mark the end of rate hikes. But unfortunately economists cannot always be spot on. Whether or not South Africa needed it, another rate hike was announced on Thursday, 7 December 2007. The latest view is that we should see the rate hike cycle peak at 15% early in 2008 – with some cuts possible toward the end of the year.

These higher interest rates will further weigh on the market. High interest rates signal the death knell for many local sectors. Those that will suffer most are the credit retailers, especially the furniture and clothing companies. General retailers like Woolworths and Pick & Pay will also suffer – while cash food retailers like Spar should prove more resilient. The automotive industry and companies supplying parts to it will also take a knock.

Van der Merwe believes banks offer excellent value at the moment – and while most analysts support this view, they advise steering clear of the sector until the interest rate cycle tops. If you get in before then, you are likely to suffer a bit more downside in the short-term. Sanlam Private Investments will remain overweight Remgro, MTN and the banking sector in the coming year. They will maintain exposure to commodity plays BHP and Anglos. We expect many retail investors will be lightening their equity exposure slightly going into 2008.

Editor’s thoughts:

Investment advisers who have attempted to predict the end of the JSE bull market rally have been burned in the past. The more cautious among us thought the market had gone far enough toward the end of 2005 – and then again at the end of 2006. But the economic sentiment as we enter the 2007 festive season has definitely turned. Is now a good time reduce equity exposure and move toward a mix of less risky asset classes? Post your comment online or send an email to  

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