Over 2010, Australian shares were arguably hit by both with double-dip worries at various points in time in Europe and the United States, but monetary tightening in China, Asia and Australia.
However, the experience of past cycles points to the resumption of better returns in the third year and we expect this to play out in the year ahead.
There are several reasons for optimism. First, Australian shares are starting the year reasonably cheap. The forward price-to-earnings multiple coming into the new year is around 12.8 times, which is below its longer-term average of 14.5 times and well below its level of a year ago when it was 15.2 times.
This suggests that risks are better allowed for and provides greater scope for a rise as investor confidence gradually improves.
Second, the continuing economic recovery both globally and in Australia should underpin further gains in profits. We expect profit growth of around 12 per cent over the year ahead.
Third, the global monetary and liquidity backdrop is very stimulatory, underpinned by very low interest rates and quantitative easing in some countries with the likelihood that some of this cash sloshing around globally will find its way into share markets, including the Australian share market.
Related to this, the corporate sector in the US, Australia and in other major countries is cashed up, which is likely to result in a further pick-up in merger and acquisition activity, share buybacks and dividends, all of which are positive for shares.
Fifth, while investor caution has seen poor inflows into share funds and strong inflows into bond funds in recent years, there is a good chance fund flows could reverse in favour of shares in the year ahead as investors realise the global and Australian economic recovery is continuing.
Finally, 2011 is also the third year in the US presidential cycle, which usually sees above average share market gains as economic policy becomes stimulatory in order to help the incumbent president.
Since 1927, the average return from US shares in the third year of the presidential cycle has been 19.4 per cent a year, compared to an average return across all years of 11.8 per cent a year. Solid gains in US shares should augur well for the Australian share market.
To be sure there are plenty of potential threats to keep an eye on, including recurring sovereign debt crises in Europe, another bout of house price weakness in the US, monetary tightening in China and Australia and the risk of a sharp rise in bond yields.
However, while some of these are likely to cause ongoing volatility, they are unlikely to be significant enough to derail the ongoing recovery in the share market.
By year end we expect the Australian ASX 200 Index to have risen to around 5500.
AMP Capital Investors chief economist Shane Oliver
