Read This Before The Coming Market Rally

The S&P/ASX 200 hit an all-time closing high of 6828 points on November 1, 2007. The future looked rosy, the economy was flying and only a very few people had any idea of what 2008 and 2009 was to bring.

With the benefit of hindsight, we can tell a pretty sorry story of the two years that followed. Credit markets froze, investment banks fell and Southern Europe’s house of cards came crashing down.

Doom-saying became de rigueur at dinner parties and on television. The world is ending, don’t you know…

It’s time to kiss good-bye to the doom and gloom…

Except that it wasn’t – and isn’t. Sure, it might have felt like that for banks and property companies which had made risky loans and taken on too much debt, respectively.

It might also have felt like that for share market investors, as the S&P/ASX 200 fell from lofty heights of near 7000 points to a low of only 3145 points by March 6, 2009.

You think that’s bad? Here’s the really sad part – many investors sold, swore off shares, and into the safety of cash. You know what’s coming next, don’t you?

That’s right – in the three years since, the ASX 200 has rallied 35%. Those investors who sold have done themselves a huge disservice.

‘Ah’, I hear you say, ‘but the market is still well off its 2007 highs’. Exactly. Exactly!

The market in 2007 was probably over-valued, so there’s no point running straight back to that point, but even if we got back to 6,000 points, there’s another 40% to go!

At the beginning of 2012, widely followed Richard Coppleson of Goldman Sachs said this in the Australian Financial Review

“That’s what you could get this year, a 20 to 30 per cent rise…”

I had to take a second look myself…

According to Coppleson, shares could soar 20 to 30 per cent in 2012!

After some dark days for Australian sharemarket investors, could we now be on the cusp of the NEXT BULL MARKET?

Am I saying that will happen soon?

If you’ve read anything from The Motley Fool, you’ll know we’re neither market timers, nor are we technical analysts. Personally, the only “double top” I know is the soft-serve variety.

There’s a very real difference between trying to pick the bottom and knowing when shares are undervalued. Looking at the ASX today, I have no idea – at all – whether we’ve seen the bottom. I simply have no way to forecast irrationality.

Sure, we’re up 30% from the recent lows, so it’d take some seriously bad news to push us back down there, but it’s possible.

What I do know is that shares are cheap compared to historical norms and that pessimism and uncertainty reign. It might be uncomfortable, but that’s exactly the time to buy. When optimism returns, the opportunity will have passed.

Most of the pessimism has gone from the US market. Including dividends, the S&P500 is now back to an all-time high. But our market has been left behind. It’s like we’re being shown what can happen, and being given a chance to get ready.

Well, do you feel ready to profit from the coming sharemarket rally?

Perpetual gloom, yet the sharemarket looks dirt cheap

There’s plenty of bad news in the market today. Bad news gets the headlines, and once the market gets on a roll, the news becomes self-fulfilling. The net result of a few years of continued pessimism is a market that doesn’t fully appreciate – or value – the earnings power of the companies on the ASX.

Not every company is cheap – there are plenty of resources companies praying that mineral prices stay at record highs – but there are enough of them to make the ASX a fertile hunting ground for investors.

The Australian All Ordinaries index has averaged between 15 and 16 times earnings over the past 25 years. It’s currently sitting around 11. At the same time, dividend yields are well over the long-run average.

The implication of these statistics is that investors, as a whole, believe the future will be much tougher than the past. In an environment of depressed consumer confidence, the market is betting that demand will be soft for a long time to come which will keep corporate profits low.

The future will be better than the past

Here’s where I differ from the crowd, and why I think now is a great time to buy. Companies that have survived the creative destruction of capitalism over the past few years have emerged in stronger shape. Consumers have already tightened their belts, and spending will pick up…just like it always has.

The future is very likely to look better than today’s market is predicting (because of its over-reliance on events of the recent past).

If you accept that assumption (and it’s been true since the dawn of time, notwithstanding occasional periods of over-reaching and pull-backs), then what becomes clear is that many of today’s prices are cheap.

Berkshire Hathaway Chairman and CEO Warren Buffett was recently interviewed by Charlie Rose on the latter’s television program. Buffett, in response to a question about whether America was in decline, said:

America’s not in decline. I was born in 1930. Just imagine that you had foreseen 25% unemployment, 4000 banks closing, the Dow going from the day I was born from 250 down to 42, I mean all kinds of things, a World War coming on… but this country, it moves ahead’.

For the record, the Dow Jones closed at 240 points the first day it traded after Buffett was born. It hit a low of 41 points on July 8, 1932. It has been through many wars, recessions, and periods of high inflation and high interest rates… and hit new all-time highs of 14,164 in late 2007.

Including dividends reinvested, the Dow is now higher than it was back then.

One last kicker – that’s the average… the return you could get from owning the index. Imagine how much better you could do by beating the average but just a percentage point or two!

We know that when corporate profits improve, share prices move with them. When companies are fairly valued, the improvement in share prices will move in tandem with the underlying profits.

Benefit twice from profit growth

But if, like today, many shares are undervalued, any profit improvement will have two compounding impacts.

Firstly, the move in profits will lift share prices, as I mentioned above. So far, so good. The extra benefit for investors who buy today is that sustainable, growing profits will have the effect of reversing the market pessimism, and price/earnings ratios will return to more normal levels.

That so-called ‘multiple expansion’ is the upside for investors who ignore the crowd and look through the pessimism – the reward that comes from thinking for yourself.

The timing of the rally might be uncertain but if you wait for the market to recognise its own moodiness, the opportunity will pass you by. Yes, you might have to wait a while for the gains to come, but if you’ve invested well, the profits will come.

Downside protection

If you’re particularly eager to protect your downside, there are a couple of things you can do to reinforce your portfolio.

First, only buy shares that have a large margin of safety – the companies which are most undervalued.

Secondly, you might want to consider quality blue chip companies that are offering solid dividend yields. There are plenty of those around at the moment (we’ll be naming them regularly in our free email updates…more on that below) and they’ll effectively pay you to wait for the market to recognise its mistake.

Foolish take-away

There are quite a few businesses trading on the ASX at very reasonable prices, some at even downright bargain basement levels.

Investors who buy shares in these businesses at current prices are likely to do very well in the years to come, even if price/earnings ratios never improve – the current price and future earnings potential will be enough.

History tells us that price/earnings multiples usually return to their averages (and higher) throughout the market cycles. If the market returns to its average, the return from margin expansion alone could be 30% or more – on top of the price increases that will come from the growth in profit.

That’s on average. Choose well, and you could do even better. Picking tops and bottoms is for mugs. Instead, just focus on buying when shares are cheap, relative to the likely future earnings.

In time, the market should do the rest.

Take Stock

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Last updated: 22nd March, 2012