Lock, stock and one smoking barrel: on Monday, net non-resident equity flows to South Africa nudged into positive territory for the first time in 10 days at 311m rand ($43.5m), as foreign investors snapped up stocks on market dips.

Net non-resident flow - Citigroup

Source: Citigroup

Was Monday a cyclical blip?

The JSE All Share Index opened lower for the first day in five on Tuesday, falling 1.02 per cent at pixel time from Monday's close, mirroring falls globally after weaker-than-expected German economic data. Year-to-date, the JSE is down 6.1 per cent but up 3.09 per cent on a five-day basis.

The Johannesburg Stock Exchange, with a $715bn market cap, is trading at a trailing PE of 12.09x, a price to book value of 1.48x and a dividend yield of 2.92 per cent, according to Thomson Reuters Eikon data.

Winds of change

Analysts are now mulling over the extent to which weaker global growth prospects will feed into South Africa's economy and exert downward pressure on earnings.

The only way is down, according to Citigroup's Jo'burg-based equity analyst Richard Schellbach in a research report published on Monday. First point to note is that historically-speaking, nominal GDP and equity market earnings growth have followed each other in step.

GDP & Earnings growth - Citi

Source: Citi

At current market prices, the 2012 consensus EPS growth forecast of 22 per cent for SA equities "clearly looks too high" and current "share prices suggest a contraction in EPS next year", reckons Shellback.

Sectors like oil, mining, metals and paper, in theory, tend to suffer sharp corrections given their correlations with global growth cycles, while domestically-orientated stocks fare better. But the Citi strategist reckons the summer of 2011 is no prelude to a 2008-style tumult when earnings estimates and equity valuations in SA were abruptly downgraded.

Put simply, markets are coming from a lower base: (All emphasis FT Tilt's)

The heavy downgrade cycle that started in mid 2008 was a product of a banking/financial crisis that caused a severe global recession. Given that markets re-rating downwards over recent weeks is still more a digestion of a lower (but still growing) medium-term global growth outlook, we can expect the downgrades to be nowhere near as severe, but possibly a bit more evenly spread across sectors.

Another contrasting feature of the current market landscape with that of late 2007 is the lack of clear overvaluation in the 2 key sectors of:

Mining — Now at its cheapest level relative to the market for ten years. The sector would still look cheap even if we factor in earnings downgrades of 20%!

Banks — are currently priced in the centre of their valuation range relative to both their own forward earnings, and the broader market multiple. With the bulk of Big-4 bank earnings being driven by SA and company-specific issues, EPS downgrades on the back of slowing global economy would be minimal.

If the worst fears play out and we head into a global recession, bank shares would still fall sharply given that valuations have clearly not priced in such a bearish scenario (PB of about 1.4, which looks cheap compared to their LR average of 1.8, however still nowhere near the 1.0 they hit in February 2009).

In aggregate, the Citi strategist reckons South African equities are pricey relative to their historical average -- after factoring in the prospect of an oncoming downward earnings cycle -- and pricey relative to EM equities:

Right now the FTSE/JSE All Share index is trading on a 12 mth fwd PE of 9.8, so only a touch below its long-run average valuation of 10.2 times. Furthermore, if we factor in that earnings are entering a downgrade cycle, possibly in the order of 10 - 15%, then the market is actually priced at a multiple of between 10.9 and 11.5 times earnings, i.e. a valuation that looks on the pricey side of its history.

...relative valuations also shine unfavourably on SA equities. In local currency terms, the market has been a relative outperformer both year-to-date and over recent weeks, such that the market’s PE is now higher relative to both EM and DM equities than it has ever been before.

As shown below in Figure 8, SA equities have traditionally traded at a 35% discount to global equities and a 15% discount to emerging market equities. The market’s relative re-rating is such that local equities now trade at PE parity with global equities, and a 7% premium to EM equities!

PE ratio - Citi

SA relative valuations - Citi

Adding fuel to this bearish view is that South African stocks, in aggregate, are seen as "over-rated", according to the broker consensus. Here's a chart that highlights the aggregate number of broker net buy recommendations for EM markets expressed as a percentage of the total outstanding recommendations.

Broker recommendations - Credit Suisse

Source: Credit Suisse

One reason for South Africa's pricey status could be that investors are in effect rewarding the country for the maturity of its market, reckons the Citi strategist.

the South African equity market is no longer the one- trick pony it once was, now having a much-better-diversified sector mix. With sector weightings on the JSE now more fitting to a developed than emerging market, it follows that a higher PE could be justified.

And here's the crucial point:

South African Equities Now Trade More like DM than EM Equities
Correlating weekly price returns over a rolling one-year period, the JSE now shows a higher correlation to moves on the S&P500 than it does to price moves on the MSCI Emerging Market Index... The steady increase in the local market’s link to US equities fits with its matured and more diversified sector mix, and a de-facto “developed market” status in the eyes of professional investors.

. Correlation of Weekly Returns between JSE All Share & Offshore Equity Markets - Citi]

South Africa has "benefited disproportionally among EMs from the recent trend of rising equity benchmark allocations to EMs by institutional investors and pension funds due to its relatively liquid asset markets", Herman van Papendorp, investment strategist at Renaissance BJM, wrote in a research report earlier in the year.

Silver lining

So in the near-term, if these Citi estimates ring true, expect significant downward pressure on earnings and earnings forecasts.

But, as FT Tilt has reported, analysts reckon there is still plenty of value in diversified miners. What's more, investors like Peter Brooke, head of Macro Strategy Investments, a boutique in the Old Mutual Investment Group SA (OMIGSA), reckon SA equities are likely to revert back to long-term average valuations, so snapping up stocks on market dips could yield decent returns in the medium to long-term. But expect the JSE to take its cues from the US equity markets like never before.

See also:
Global market rout - the impact on Sub-Saharan Africa - FT Tilt
Global market rout - the outlook for South African assets - FT Tilt
South African investment tactics: equities to dethrone bonds - FT Tilt
Coverage of South African stocks - FT Tilt