Knock! Knock! Who’s There? It’s The Pause That Refreshes

This story features ANZ GROUP HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: ANZ

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

Behind every record high for the share market lurks a new danger. What could possibly go wrong this time? Many signals point at a stronger US dollar. But how could this be, I hear you ask, isn’t everyone bearish on the US dollar?

Exactly.

Financial markets have a striking similarity to your average midsized fisherman’s boat. If every passenger leans over to the same side chances are the boat will turn over, forcing all and everyone to show their swimming skills.

Since the Federal Reserve cut interest rates by 50 basis points in September financial markets almost instantaneously turned homogenous: everyone went short the US dollar, long commodities, got rid of government bonds, and rediscovered risk.

The results have been very predictable: from New York to Shanghai to Sydney share markets have surged to new all time highs, led by resources and energy stocks, while the US dollar fell to new lows against currencies such as the euro and the Canadian and Australian dollar, oil briefly touched beyond US$80 per barrel and gold has been pushing US$750/oz.

And now, it seems, everyone is leaning towards one end of the boat…

One would assume that all it takes is for the market’s pre-defined scenario for a widening interest rate differential between the US and the rest of the world to become a little less certain,.. and that’s exactly what is happening right now.

Last Friday’s monthly update on the US jobs market suggests the US economy might be stronger than expected – or at least not as weak as the darkest scenarios in the market. Were this to be confirmed by more data in the weeks ahead the Federal Reserve might well elect to wait and see what happens first before cutting interest rates further.

Meanwhile, concerns are rising about economic prospects for Europe, including the UK, and Japan. The European Central Bank may act as if it still has a tightening bias, but a growing number of experts are suggesting the ECB will soon come to the conclusion that Europe will once again bear the brunt of this latest global financial crisis.

History shows Europe usually is the main victim even though these crises seldom originate on the old continent itself. Japan, on the other hand, may already be experiencing a technical recession after economic growth turned negative in the second quarter.

These developments are taking place at a time when many a market watcher believes commodities from oil to gold to copper, and even wheat, have either run into technical resistance, or are looking overbought – or both.

As such, Monday’s market movements may have provided us with a glimpse of what might lay ahead of us: as the greenback staged a mild come back against most major currencies, the November Nymex crude oil future fell by 2.7% to US$79.02 per barrel (minus US$2.20); markets in London and New York saw Nickel fall by more than 4% while prices of zinc (down 3.6%) and copper (down 3.1%) barely fared better; the December Comex gold contract fell by US$8.50 (1.1%) to US$738.70 an ounce.

Despite mining stocks retreating on Tuesday as a result, the Australian share market still managed to post a new record high as buyers flocked into banks and industrials instead. But here’s another interesting observation: out of the five major local banks three are currently trading above their respective average price targets, while ANZ ((ANZ)) shares are at their average twelve month target. This leaves only National Australia Bank ((NAB)) with less than 4% left between share price and average price target of $43.13.

Historically, when local banking stocks surge past their average price targets this indicates further upside is limited and a share market retreat soon follows. So far, we haven’t noticed one single occasion over the past five years when this hasn’t happened.

The situation is similar for those resources and energy stocks that have been the major drivers behind the recent record run for the local share market: Woodside Petroleum ((WPL)) shares are more than 6% above their average price target of $48.53, BHP Billiton ((BHP)) shares are also above their average target of $44.44, but shares of Rio Tinto ((RIO)) are still some 6% off their target.

The latter does not necessarily indicate that Rio Tinto shares have more upside potential left for the short term. It is likely the opposite as indicated by a research report by GSJB Were on Tuesday.

The resources analysts believe that as the global investment community is starting to add Alcan to its Rio Tinto group forecasts short term headwinds are building, mainly because of a slump in the spot aluminium price, but also because of currencies movements.

At the time when Rio management announced the Alcan takeover spot aluminium was trading at US$1.259/lb. GSJBW points out the average aluminium price for the second quarter this year was US$1.253/lb, which is only a fraction lower. Since then, however, spot aluminium has fallen to US$1.079/lb.

The result will be significantly lower earnings contributions from Alcan. A stronger Aussie dollar, euro and Canadian dollar all add extra weight on future earnings estimates. What this means is that as securities analysts update their valuation and forecast models, including for the acquisition of Alcan, earnings estimates for Rio Tinto are actually trending down.

The good news is that most of the above mentioned problems are likely to be temporary and thus any pull back for the share market is likely best considered as a pause that refreshes rather than the end of the bull trend.

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