Here’s why investors are suffering from altitude sickness

After a touch of May mania, markets have copped some early June jitters. Lacking any strong conviction, and after seven sensational weeks of a climbing Australian sharemarket, investors look prepared to push share prices so high, but no higher.

How far exactly? Consider these numbers.

Since the mini-crisis of August and September last year, the ASX 200 index has made a few forays towards 5400 points, but has either fallen short or, more recently, broken through — only to then topple.

It’s a similar story in the United States with the S&P 500, which suffers altitude sickness around 2100 points, and for London’s FTSE 100, where the barrier stands 6400 points high.

Now, I’m no numerologist (or, if you prefer, technical analyst), but those nice round numbers stand out like a sore thumb.

The phenomenon is supported by some intriguing results from the American Association of Individual Investors’ sentiment survey. This asks individual investors where they think the market is headed over the next six months, and puts them in the “bullish”, “bearish” or “neutral” camp.

It’s a weekly survey and can be pretty flighty, but every time the S&P 500 has approached 2100 points over the past year or so, the “neutral” sentiment has spiked. In other words, as prices climb investors increasingly doubt whether stocks can make another leg higher.

Psychology is at play.

Still, it all seems terribly arbitrary: putting limits on sharemarket rallies based on a neat multiple of 100. But if you lack conviction, it’s as good as reason as any to stop buying. So why the lack of conviction? There are a few reasons.

First, there’s a whiff of changing narratives in the air. As I wrote last week, it’s dawning on investors that maybe higher rates won’t lead to another meltdown. Maybe the US dollar won’t charge higher and sink emerging markets.

Oil continues to climb and may not be the destabilising force it was in 2015. Perhaps the US economy is fit enough to handle tighter policy. It’s even possible that China is not about to fall over in a heap.

Those are a lot of “maybes”. They are all reasons to be optimistic around the medium-term outlook, but only time will tell.

“If cash is king, then it’s wearing a hair suit.”

So why not wait and see what happens when the Fed does raise rates? Or after the UK referendum on June 23? Or Spanish elections this month, or our own vote on July 2?

Why take the risk now?

That brings us to the second reason investors are prepared to go only so far, and this is really the crux of it all: the risks are obvious but, given lofty valuations married with very limited growth prospects, the rewards are much less so.

“The return to more normal market conditions has increased investors’ sensitivity to macro risk because prospective returns seem low relative to investment risk,” Gerard Minack of Minack Advisors writes.

“Better macro data would help, but investment risk-reward is now structurally poor.”

That’s why Minack reckons after a long time in which “cash was trash”, this year cash may be “the (risk-adjusted) king”.

Well, if it is king, it’s wearing a hair shirt.

There’s precious little on offer from term deposits in Australia, and even less overseas where rates are negative and a third of government bond yields are below zero.

Negative yields are also becoming more common in global company debt markets, a trend that can only accelerate as the European Central Bank gears up to begin buying corporate credit in the coming days.

This brings us to the third and final reason why equity markets keep bumping along, rather than making a significant break one way or the other.

The gap between the 90-day bank bill rate and the dividend yield on the Aussie sharemarket is at 2.9 percentage points — its highest since at least 1960, if you exclude the GFC period when equity prices cratered. And that’s before franking.

But scepticism around the dividend trade is rising as companies struggle to support historically high payout rates.

The aggregate payout ratio of ASX-listed businesses is pushing 85 per cent, Russell Investments strategist Graham Harman says. And in order to appease income-hungry investors, company boards have sacrificed investing in their own businesses.

“The corporate sector is fluffing up the yield at the cost of future growth,” Harman says. “That means that shares are now almost no-growth — more like a bond.”

This trend has a use-by date because the tension between falling earnings and rising payout ratios eventually becomes too great — witness ANZ’s recent decision to cut its dividend.

Failure to invest in future growth is a worry. Because what will drive share prices higher in the medium term will have to be earnings growth.

The profitability of the ASX-listed corporate sector, as measured by return on equity, is around its long-term average, Harman says. Full valuations and average profitability is not a happy marriage for prospective share price gains.

“That’s the thing we really do watch for, because you need to see that [revenue] strength come back,” JP Morgan Asset Management global strategist Kerry Craig says.

“These markets have been going well for a long time but you’ve never seen that real boost to revenue growth that you should have seen by now.”

In the meantime, investors around the world are being “paid to wait” via dividends, as Craig nicely puts it.

And so we wait.

This story first appeared on afr.com.

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