By Greg Peel

The sharp sell-off in Australian and other global equity markets in the past few days has highlighted the vulnerability of equities, notes Citi, to a tapering off of liquidity being provided by the Fed. The concern is that the rally could now be over.

Citi had been holding a year-end target for the ASX 200 of 5200, so having hit that level earlier this month, the market has been running ahead of the analysts' expectations. The correction has now levelled the ground a little, and Citi thinks further gains are still "probable", but it was inevitable that at some point the pace of the rally had to slow.

Australia's net market multiple (price/earnings ratio) is still only around average, so if moderate earnings growth is achieved in FY14 as expected, a modest rise in bond yields should be absorbed. A sharp rise in bond yields would be more problematic, but Citi believes this unlikely given the cautious approach the Fed seems intent on taking.

FY14 earnings growth should be supported by lower interest rates, corporate cost cutting, and more recently, a weaker Aussie dollar. Citi has thus upgraded its year-end target for the ASX 200 to 5400 from 5200, with 5600 forecast for mid-2014. The broker believes the pullback in banks and defensives could run further, with cyclical sectors holding up.

JP Morgan has looked at the market PE ratio in a different way.

Where appropriate, stocks are most often valued on a "discounted cash flow" (DCF) basis, with the discount rate being represented by the "risk free rate" plus a "risk premium" appropriate to the individual stock. The government ten-year bond rate is the closest thing we have to a "risk free rate", and that's currently 3.3%. As investors have chased the yield provided by stocks in a low interest rate environment, they have affected a "discount rate rally", suggests JP Morgan, which is another way of looking at the increased market multiple, or PE ratio.

The recent sharp sell-off is not just noise, says JPM, but a signal that the market had already reached a reasonable balance of risk free rate and risk premium. The last leg up has been more about momentum than valuation. If there is no further near term upside left for PEs, stocks that look rich on non-yield valuations are vulnerable. JP Morgan's Model Portfolio is now Underweight banks and infrastructure and has lightened up on Telstra ((TLS)).

Credit Suisse has also questioned whether the focus on yield has gone too far. For CS, the resources sector provides the clues.

Over the past month, Australia's biggest energy company, Woodside Petroleum ((WPL)), has become a yield play rather than a growth play. In handing back capital, Woodside has effectively signalled to investors that the company cannot find growth projects that will provide a sufficient return beyond the cost of capital, hence it might as well hand the money back. Investors lapped it up, then turned their attention to the big miners BHP Billiton ((BHP)) and Rio Tinto ((RIO)) to do the same. After all, both BHP and Rio have also shelved growth projects over the past year.

BHP and Rio have refused, pointing to ongoing growth projects, such as Pilbara iron ore expansion, which still offer solid return on capital. Investors were displeased. Credit Suisse notes that the big miners BHP, Rio and Fortescue Metals ((FMG)) have underperformed the big energy companies Woodside, Santos ((STO)) and Oil Search ((OSH)) by 21% over 12 months.

If Credit Suisse assumes its DCF modelling to be accurate, working backwards from stock prices implies the market is pricing both Woodside and BHP on the basis of reinvested cashflow offering little to no net return on surplus cash, Santos is priced to generate a 4%pa return and Rio is priced to generate a negative return of 5%pa. This suggests to the analysts that the market is willing to pay up for a dividend yield but will give little or no value to companies that can reinvest cash for a positive return.

Note that yield is for "today" and reinvestment is for "tomorrow".

Rio thus appears cheap amongst resource sector peers, Credit Suisse suggests, albeit the analysts do acknowledge nervousness surrounding weaker Chinese data and the implications for iron ore. Oil Search has rallied 11% in three months and at the same time, Rio has fallen 18%.

The yield rally has also been brought more sharply into focus with the sudden de-rating of the Aussie dollar. Returning to expectations for increased earnings in FY14, as noted above, Deutsche Bank points out that if the exchange rate sat at US$0.95 through FY14, earnings would be 5% higher than previously assumed. At US$0.90 they would be 9% higher.

The split favours resources, such that while industrials earnings would only increase by 3-5% (on 90c), resource sector earnings would increase by 12-22%.

Deutsche Bank does not actually expect currency weakness to persist, but if it were to, the analysts point out the greatest beneficiaries as being Woodside, Alumina Ltd ((AWC)) and Iluka Resources ((ILU)) among the resources, Incitec Pivot ((IPL)), Bluescope ((BSL)), CSR ((CSR)) and Aristocrat Leisure ((ALL)) among the cyclical industrials, and ResMed ((RMD)), QBE Insurance ((QBE)) and Treasury Wine Estates ((TWE)) among the defensives.