The dust has now settled on Australia’s stock market performance in 2014 and many investors have been left somewhat underwhelmed. Looking at how the market ended the year, however, there is a good chance of better gains in 2015, especially if interest rates stay reasonably low and the benefits of the lower Australian dollar flow through into improved corporate earnings.

We also need a sense of perspective. At a time when the economy is struggling, we can’t expect booming stock market returns every year – especially after the heady gains in 2013 and 2012.

For the record, the S&P/ASX 200 index returned only 1.1% in price terms last year, which was much less than the average gains of around 15% in each of the previous two years. It is also a bit shabby in the face of the 11.4% price return from America’s S&P 500 index, which also posted a massive 29.6% return in 2013.

Wall Street in the past few years has shown the local market a clean pair of heels.

Add in dividends, however, and the total return from the Australian market rises to 5.6% in 2014 – which is still better than cash. And we could gross this up by a further 1% or so to allow for the benefit of franking credits. At a time of below-trend economic growth, and feeble returns on cash, equities still posted a reasonable return.

What drove this market result, and what’s the outlook?

Note we can divide the market’s price performance into two component parts: that due to earnings, and that due to changes in the price to earnings ratio. In turn, the market’s actual earnings performance can be split between the earnings growth expected at the start of the year, and the change in earnings expectations through the year.

Similarly, the change in the PE ratio can be split between that caused by a change in interest rates, and that caused by a change in the “risk premium”, or gap between the market’s earnings yield (inverse of the PE ratio) and interest rates.

Last year, for example, all of the 1% increase in market prices was caused by a modest 1% increase in the market’s estimate of forward earnings (as calculated by Thomson Reuters). Note, however, that at the end of 2013, consensus analyst expectations were such that forward earnings were expected to rise by 8.5% by the end of 2014 – so we’ve had a 7.5% downgrade in forward earnings expectations over the year.

No prizes for guessing which sector was most responsible for the earnings miss – materials (containing our large mining stocks). At end-2013, forward earnings for the materials sector were expected to grow by a modest 7.5% through 2014.

The actual result was a decline of 17%.

Earnings were also downgraded in the energy, consumer and utilities sector, though thankfully expected earnings in the key financial sector actually improved slightly.

The price-to-forward earnings ratio, meanwhile, remarkably ended the year at the same level of 15.5 as it ended 2013. The big difference, however, is that interest rates (measured here by the 10-year government bond yield), fell through 2014 – from 4.3% to only 2.8%. The result is that the share market’s valuation relative to interest rates – as measured by the gap between the earnings yield and bond yields – rose from a slightly below-decade average 2.6% to a nicely above-average 4.1%.

The outlook

It means that if interest rates stay reasonably low, the PE ratio might be pushed higher next year. Indeed, even if 10-year bond yields rose to 3.5%, and the earnings to bond yield gap narrowed to its near-decade average of 3%, the PE ratio could rise to 15.4 – adding 6% to market prices even before we consider any possible contribution from earnings.

Of course, at 15.4 – the PE ratio would then end next year well above its longer-run average of 13.5 – and so would be vulnerable to dragging the market lower again were interest rates to rise in earnest in 2016. Hopefully by this time, however, the economy would have picked up enough steam that earnings could be staging a strong rebound.

As for earnings, analysts currently anticipate forward earnings will rise by just under 8% through this year. But this critically depends on the materials sector forward earnings achieving solid gains, rather than slumping badly (again). Given the recent further decline in commodity prices, there’s some risk of further downgrades in material sector earning expectations through this year.

But against this, the benefits of a lower Australian dollar should also start to translate into higher Australian dollar returns for listed exported companies (including the miners). The Reserve Bank also seems open to cutting interest rates again should the upturn in the housing sector start to falter, which bodes well for financials and the economy more broadly.

And we should also not forget that irrespective of what happens to prices, investors should continue to enjoy a dividend yield of at least 4% – and a little more after franking credits are allowed for.

All up, the market’s attractive valuation relative to interest rates, plus likely continued low local interest rates and the weaker Australian dollar, bodes well for shares. Further modest total equity returns seem most likely, though investors should also be on guard for potential global shocks – such as further jitters over the sustainability of the Euro, and rising interest rates in the United States.

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