New data released by Northcape Capital has revealed that the Australian share market generated an 11% return in the first 10 months of 2024, beating the 8% average over the past two decades.

Major players include banks, insurers and Macquarie Group, which deliver 30 to 50 percent returns to their shareholders.

However, the fund manager described the rally in big banks as “intriguing” given that companies in the sector reported lower earnings in 2024. and have a “flat” earnings outlook for the coming years.

Northcape attributed the increase in the share price to a revaluation of new all-time record price-earnings (PE) ratios.

As the market is expected to start in 2025. at relatively high valuations compared to historical levels, the fund manager warned that some sectors could be particularly vulnerable.

"The most vulnerable sectors, in our view, are those that have seen large share price gains that have not been fully supported by fundamentals," the firm noted in its Australian Equities: Market Outlook 2025.

Nordkape emphasized that the banking sector covers nearly a quarter of the domestic market. This means that today's passive investors allocate a quarter of their portfolio to a sector trading "at historically extreme valuations in virtually every metric."

The firm noted that Australian banks had posted disappointing earnings in 2024, with little prospect of significant improvement in profitability or returns going forward.

Consensus forecasts suggest that earnings per share (EPS) growth for the sector will remain at 1 to 2 percent annually over the next five years, while returns on assets have stabilized at much lower levels than their 2015 peak.

In addition, traditional banks are facing increasing competition in the retail banking space from rivals such as Macquarie Group that are unencumbered by legacy IT systems.

"Momentum behind banks may continue for some time, but we would expect some moderate recovery over the next 12-18 months," the firm said.

Australian technology stocks

Another sector trading at high levels is Australian technology, which has seen a strong rebound over the past two years, Northcape noted.

Tech stocks are driven by solid organic sales growth, high margins and reinvestment opportunities.

However, the firm cautioned that current estimates leave little room for error.

"The outlook remains favorable, but current estimates have been raised to high levels, with no margin of safety," the firm noted.

Investors should be aware that any external shock, such as a correction in US tech stocks due to concerns about future returns from AI capex or a sharp global economic slowdown, could trigger a sell-off in the Australian tech sector.

On a more positive note, Northcape has identified opportunities in the healthcare and infrastructure sectors, as well as individual stocks such as Brambles, Qantas and James Hardie. It also notes that opportunities can be found in selected industries undergoing structural change.

“Our portfolio has significant infrastructure exposure through our holdings at Transurban and Oakland International Airport.

“These stocks have underperformed the market in 2024. and now offer excellent value at reasonable valuations and the prospect of protected long-term dividend growth,” it said.

The firm also pointed to the airline sector, which has seen "better capital discipline and pricing" recently.

Overall, Northcape expects a mixed outlook for the Australian equity market in 2025.

While some economic pressures are expected to ease, lower commodity prices and a weak outlook for bank earnings are likely to weigh on overall earnings growth.

Moreover, delayed interest rate cuts further increase uncertainty.

"In today's environment, it is extremely important to pick stocks that will be sustainable through the business cycle," it said.

"Moving into 2025, we remain focused on companies that were overlooked in 2024 but are still generating solid returns on capital with additional growth opportunities."