Rudi's View | Oct 12 2011
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck, Editor FNArena
An increasing number of share market experts has started talking "rally", not necessarily in the weeks leading up to Xmas and the year-end, but right here and now. With the overall news flow about Europe poised to remain ambiguous at best in the short to medium term, what are the chances we will see more than just a temporary flare upwards led by short covering and dare-devil day traders?
It goes without saying, at inflection points like the one we are encountering this month, there are at least as many good reasons as to why equities should rally as to why they should first weaken further. Below I have lined up the most commonly mentioned factors on both sides of the ledger:
On the positive side:
– Equities are cheap on virtually every possible valuation and comparison method; vis-a-vis government bonds, vis-a-vis historical averages, on implied dividend yields, on corporate cash flow levels, on Price to Book valuations, et cetera
– Mining stocks and banks (the two leading sectors in Australia) both look ultra-cheap, not only in comparison with historical references but also in comparison with defensive stocks that now have outperformed for most of this calendar year
– Banks often lead the share market in general and the sector is about to report FY results, while offering high and sustainable dividends, and with the bond market increasingly convinced the next move in the RBA's cash rate is down, not up
– History shows bank stocks usually start outperforming in the lead up to RBA rate cuts (this could bode well for the share market in general)
– Technically, risk assets seem poised for a relief rally, at the least
– Globally, investor sentiment readings are again close to historic lows while cash holdings of super funds (and other investors) and households are at decade and a half highs, suggesting an ever diminishing pool of potential sellers
– Also, the current market recovery measured from the peak in November 2007 is now lagging similar recoveries post burst bubbles in the twentieth century (even in comparison with post 1929)
– Historical analysis suggests returns are highest when the US Vix index sits in between 40 and 50; last week the Vix rose to 45
– History also shows we have now entered the most profitable period for owning equities (October-April as opposed to May-September)
– While most forecasters have now incorporated a recession for Europe, many maintain the US will remain in the positive next year while Emerging Markets remain strong, suggesting there's limited downside to economic and earnings forecasts
– More government stimulus will follow in case of further deterioration, while interest rate increases are now off the agenda, everywhere! (note central banks in Brazil, Russia and Pakistan all cut rates recently)
– Market positioning for commodities is now net short, which is often a precursor for the next rally, not necessarily a sign of more weakness
– There are virtually no stocks left trading above the 200 day moving average; earlier in the year that percentage rose to historical peak levels
– Earnings estimates in Emerging Countries seem to be stabilising
– Economic data in the US are no longer disappointing
– European leaders will ultimately sort out their sovereign debt and bank system problems, the process is already starting to look promising
– Leading indicators, such as manufacturing and services PMIs around the world, appear to be stabilising
– History shows a negative performance in September is usually followed by a positive performance in October
– Increased volumes into equities rallies last week signals at least part of the "money on the sidelines" is keen to re-enter once the extreme volatility has subsided
– The overall news flow has been extremely negative since May, a simple no more negative news will likely provide relief and thus an opportunity for investors to re-assess and re-enter beaten down equities
On the negative side:
– In an environment of such elevated macro risks, apparent cheap valuations for equities do not necessarily imply equities will indeed turn out to be genuinely "cheap"
– Global equities are going through a long-term de-rating process, so cheap P/Es and valuations are likely to become cheaper still, though not necessarily in a straight line south
– Price-Earnings ratios (P/Es) are low because of weaker share prices, but earnings forecasts still have to come down more. This automatically pushes up P/Es and will make equities a lot less "cheap" than they appear to be
– Global earnings estimates have just entered a down-cycle; history suggests this process takes much longer and will continue weighing on equities while ongoing
– Copper has now corrected to well below the price low seen on August 9 this year, assuming copper retains its leading role for other risk assets, this is a bearish signal
– Equities may look cheap, but history (as recent as 2008-2009) shows they can get a lot cheaper still
– Chartists with a bearish view acknowledge a sharp rally seems to be building in equities, but they maintain the downward trend will resume once this rally is completed, sometime next year
– Corporate profit margins in the US are at peak levels, this will make continued strong earnings growth a challenge, in particular from FY12 onwards
– Corporate profit margins for global miners are back at 2007 peak levels too, suggesting the sector offers less upside than commonly assumed (medium to longer term)
– The political process in Europe remains convoluted and with built-in barriers, which means high volatility rather than a swift process is here to stay, while more banks will need bailing out, and more sovereign credit downgrades will follow
– Greece will default – we have as yet still to discover how exactly this is going to impact on… everything, really
– Equities rallied in October 2008 too, only to fall much lower once the rally had run out of breath
– Contrary to popular belief, five or six months of declines do not guarantee positive returns in the year ahead
– This is a modern day depression; not one single major economic indicator in the US has made it back to prior cycle highs during the post 2007 recovery, depressions typically last much longer than your cyclical recession for which the typical duration is 18 months
– Many of the pre-2007 excesses in debt, leverage and credit-led consumption are now mean-reverting which implies previous over-shoots to the upside will now be replaced by under-shoots to the downside
– The US dollar seems to have started a medium-term uptrend. This, history shows, tends to coincide with either weaker equities or at least a brake on rallies
Below are some charts and tables that illustrate some of the points above.
Chart 1 (above): Ten year rolling returns have now started to slightly improve, after having fallen into negative territory, which in itself is a rare event. While by no means a positive trigger point, this would seem to suggest the way forward looks brighter in comparison to what markets have been through already.
Chart 2: On some calculations, priced in risk premia for equities have now risen to +3 deviations above standard practice, again a rare event. This adds further weight to the argument that equities are now cheap as chips.
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Chart 3: Relative comparisons now suggest defensives are becoming expensive relative to cyclical stocks.
Probably best to remember: in case of a rally, those that fell the furthest have more upside potential. Longer term investors should avoid getting confused.
(This story was originally written on Monday, 10th October 2011. It was sent in the form of an email to paying subscribers of FNArena on that day).
Below are a few recent stories that might be of interest (for those who missed them or whose memory can do with some refreshing):
– How Not To Be Your Own Worst Enemy