Commodities Out, Banks In (For Now)

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

(This story was first published on Monday and sent as an email to subscribers of FNArena)

By Rudi Filapek-Vandyck, editor FNArena

The idea of a bear market rally has been put forward so many times over the past ten days that on this basis alone we must now consider the odds for a market rally in the short to near term to be better than equally balanced. For every ten retail investors and self-super managing retirees now stands at least one hedge fund trader or professional fund manager with a deep ingrained desire to see share prices move up for longer than one or two days in succession; all this market needs is a bit of positive momentum, or more likely the absence of more negative news and the hope for such a rally could well become reality.

The irony is, of course, that if such a rally were to materialise it would be more a case of “ignoramus rules” than any proof the world’s problems have been decisively dealt with. As a matter of fact, it is hard to ignore the fact that if anything this world’s problems have only continued deteriorating with US investment bank Bear Stearns ending up as the latest prominent casualty and with the US Federal Reserve’s recent interventions likely to have saved Lehman Brothers and possibly one or two more US financial institutions from going under. In Europe, central bankers and bankers have worked through the Easter long weekend to prevent further fallout from happening.

Even though the crisis has only continued to deepen since the term “subprime mortgages” started to attract the world’s attention in June last year, chances are financial stocks will become the outperformers in the weeks ahead. Especially if authorities and central bankers can prevent another Bear Stearns-alike fiasco this may well instigate general relief and thus the oft suggested share market rally.

Apart from the usual “banking stocks are cheap” mantra which many stockbrokers and other experts have held up since November last year, and which is bound to be repeated if markets are granted a few days without any more negative news, there are a few factors clearly in support of rising banking stocks at the moment. For starters, if you are looking for a trading profit in the short to medium term, where do you think your best chances are: with a sector that is trading at its highest PE (price-earnings) ratio for many years, or with one that is trading at its lowest valuations for many, many, many years?

Stocks of financial companies have been sold down by 70-80%, sometimes even more, in the US and in Europe. Pure logic tells you that anyone with cash at hand looking for an opportunity is likely to think: it’ll be far more easier to make a 10% gain from these shares than from the ones that are already trading at relatively full valuations.

A recent survey by Merrill Lynch found professional investors in the US had been swapping assets for cash over the past few months. The overall percentage of funds held in cash is now at the highest level for many years. At the same time there is a growing feeling the market’s consensus trades had become overcrowded. Let’s face it: until a week ago everyone and his stepbrother, mother-in-law and dog plus pups had gone long precious metals, short US dollar, long soft and hard commodities, short financials worldwide.

Now, all of a sudden, the US dollar seems to have started a bounce back. It’ll likely prove temporary, but it is also likely that in the current market context this will act as a trigger for overall re-adjustments. The fact this happens at a time when speculators and investors are forced to sell assets because investment banks worldwide are reducing risks and exposure and calling in their loans is acting as a quadruple blow to the sector. The speed with which this process is taking place is simply mind boggling and certainly unprecedented, even for the always volatile resources sector.

Only a week ago shares of BHP Billiton ((BHP)) were testing resistance at $40. They are now likely to test $32 anytime soon. And BHP Billiton is only one example, and far from the worst in a sector that is feeling selling pressure coming from all corners at the moment. Global deleveraging is clearly going to hurt commodities the most, as this has been the prime destination for leveraged investments thus far. For investors who have been loyal to their shares in resources companies throughout this year’s market turmoil, the taste will be rather bitter as problems inside the global finance sector have weighed upon share market performances overall and in this process share prices of resources companies have failed to keep pace with the performance of their key products. But now that prices for precious metals and commodities, both hard and soft, and including energy, are correcting lower share prices for the likes of BHP Billiton, Rio Tinto ((RIO)), Newcrest Mining ((NCM)) and Woodside Petroleum ((WPL)) seem to have only one way to go: south.

Don’t expect this to end anytime soon either, experienced market watchers are talking about “possibly several weeks”.

Mind you: what makes this correction truly unprecedented is the fact there has been no deterioration in the fundamental outlook for BHP Billiton, or for iron ore, or for oil, nor for copper. Instead, stockbrokers have been raising their forecasts for metals, energy and other commodities recently as the stronger for much longer theme simply continued throughout the first quarter of the new year. The number of Super Cycle skeptics who are again considering that prices may not start weakening in any significant manner until next year (as happens this time around each year) is growing and earnings expectations for the sector are moving up (while forecasts for all other sectors are still trending down).

For the banking sector the opposite is still happening: more and more experts come to the conclusion they have been structurally underestimating the severity of what once started as a seemingly contained subprime problem in the US housing market. The overall realisation seems to be that the global financial environment may never return to how it was only twelve months ago (probably not for the current generation anyway). Certainly, the time required to fix the structural problems and to clean up all the mess afterwards will be longer than previously assumed.

In Australia, earnings forecasts for banking stocks continue to trend south. However, if the above mentioned relief rally will ensue, this is very unlikely to prevent banking stocks from taking the lead in the overall leap ahead.

For investors, how to respond and to deal with this sudden market trend reversal is probably best dictated by their investment horizon, and by their longer term beliefs.

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