Heavyweights hold key to market upside

The ASX200 failed at the critical break out point again and the Reserve Bank of Australia kept rates on hold, although gave the best indication that there are cuts ahead if April inflation data is weak.

The next question is, will banks pass them on and, if so, what effect might that have on equities?

Recently, there has been a lot of commentary about the underperformance of the Australian share market compared to its offshore counterparts.

In the past two months, the S&P/ASX200 Index although trading in the upper end of its trading range has traded flat, trailing a 7 per cent rally in the United States' S&P500 Index and a 3 per cent increase in the United Kingdom's FTSE100 Index.

With everything from the high Australian dollar to the messy political situation in Canberra being blamed, it's useful for us to take a closer look at what is driving our index before jumping to conclusions.

Firstly, by way of background, Australia's most closely followed share market index is known as the S&P/ASX 200 Index, which comprises Australia's top 200 companies listed on the ASX.

This index began in March 2000 and is reviewed quarterly by Standard & Poor's.

What is important to note is that the 10 largest S&P/ASX 200 companies make up just under half of the index's value.

Of those 10 companies, there is a high concentration of financial and resources companies, with them occupying the first five positions as well as seven of the top 10.

So our market is primarily driven by the movements in our major banking and mining shares, and so this becomes a major reason for our underperformance.

Both sectors have been de-rated at the same time, making it difficult for the Australian share market to keep pace with the strong rallies being experienced elsewhere.

The banks have been de-rated due to lower credit growth expectations and are being valued more like well established utility companies (earnings multiples of 9-11x and dividend yields of 6-7 per cent).

The average estimated long-term earnings per share growth for our major banks is just 4.4 per cent per annum.

But it seems this de-rating has run its course with banking stocks recovering over the past fortnight ahead of the reporting (and dividend) season starting in May.

The resource companies are being de-rated as revisions are made to China's growth outlook and commodity price forecasts.

Despite this, our resource companies are forecast to offer the greatest long-term earnings per share growth on the share market. This is due to volume growth offsetting price declines and the impact of large share buybacks concentrating the earnings per share.

But risks are high as uncertainty reigns over the extent of the Chinese slowdown.

The upshot is that our share market has probably already 'priced in' most of these issues, with the S&P/ASX200 Index trading on 11 times forecast FY13 earnings versus the long-term average of 14-15 times.

These low expectations are now a good starting point for share market upside should we have any positive surprises and could be a trigger for the breakout all technical traders are waiting for.

Information contained in this article does not consider your personal circumstances. You should consult a stockbroking professional before making any investment decisions. Sentinel may hold positions in stocks discussed from time to time.