The JSE defies gravity …. for now!

The JSE defies gravity …. for now!

As I wrote in my previous blog post, iTrade Fantasy League Announcement, share prices on the JSE have run far ahead of earnings expectations. The JSE All Share Index increased by more than 30%, from 38,000 on 24 June 2013 to 50,000 in May 2014. This was much more than earnings (profit) growth with the result that the P/E ratio increased from 12 to more than 19 times. On a P/E ratio of 19, the JSE is in heavily overbought territory, more than one standard deviation above the mean. Unless earnings growth catches up quickly, this often leads to a healthy correction with share prices declining.

JSE P/E Overbought

We were recently bombarded with very bad economic statistics. Our real GDP declined by 0.6% in Q1 2014, +3,8% in Q4 2013.  This was the weakest quarter since the second quarter of 2009 when we recovered from the previous recession. The main reason for the decline was a drop of 24,8% in the mining sector (+10% in Q4 2013). Manufacturing also recorded a small decline of 4,4% (+12%).

There are still no signs of an end to the strike on platinum mines and even if it ends soon, it will take a few weeks for production to resume fully. The result is that we can expect even worse from mining in this quarter. The strike only started to affect platinum output in February (down 15% from the previous quarter’s average) and March (down 43%). We cannot expect output to improve from the March levels in this quarter and Q3 will improve only gradually if the strike ends now. On top of that there is now talk of a strike in the metals industry. The new Mining Minister is also not perceived to have the ability to take mining out of its crises. He was called clumsy and a nationalist by an expert in the industry.

Another important barometer of the economy is the Purchasing Managers Index. A reading below 50 indicates a contraction. The Index for May 2014 plunged to 44.3 from 47.4, indicating conditions and prospects in SA manufacturing industry are worrying. This is a very good leading indicator for manufacturing production. Retails sales and vehicle sales are also disappointing to the downside. On top of that it looks like the Rand has turned the corner and is again weakening with a potential rating downgrade looming in the future. We can go on and on about economic weakness. Despite all this the JSE is making new all-time highs. That is not sustainable.

The following graph uses 54 years of data to plot the correlation of real earnings on JSE listed shares and real GDP growth. With an 88% correlation (R), one can conclude that there is a strong relationship between company earnings and GDP growth, as can be expected.

economy GDP JSE earnings

For the reasons above I am of the opinion that the JSE is under serious risk of a correction of at least 5% to 10%. The decline will not necessarily affect shares like Richemont and Naspers, which earn most of their profits overseas. It will mostly occur in South African based industrial shares which are quite expensive.

Gerhard Lampen.

Head Sanlam iTrade.

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