Bears And Bulls United

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(This story was first sent as an email to paying subscribers on Wednesday morning)

By Rudi Filapek-Vandyck, editor FNArena

There are probably more than a hundred reasons why the current upswing in equities cannot last, and only a dozen or so why it possibly can. Fact remains, however, Australian shares seem on their way to post a second positive month in succession.

This now raises the obvious question: Is this the point where yesterday’s bear market morphs into tomorrow’s new bull market or are we simply kidding ourselves?

Those in favour of a positive view happily refer to what happened under similar circumstances in 1990. Back then the financial crisis was known as the Savings & Loans crisis and if we are to believe those old enough to remember it looked just as devastating and as crippling as what we’ve experienced since mid last year.

As US banks went bankrupt or saw their balance sheets becoming severely damaged, the US stock market lost 20% of its value in three months. Five months later, however, and upon confirmation the US economy had fallen into a technical recession, the S&P500 index soared to a new high.

This time around, so goes the bullish mantra, there’s more than just a small chance the US might avoid recording two consecutive quarters of negative growth (there hasn’t been one so far though expectations are the current quarter might be the one that finally brings negative growth); so what are the chances of copying the scenario of 18 years ago?

The question seems appropriate since various key elements that helped the stock market to new highs back then, have been repeated this time around. Back then the Federal Reserve Bank aggressively cut interest rates to prevent worst case scenarios from turning into reality -official interest rates fell from 8.25% to a cyclical low of 3%- plus there was a widespread belief the Fed would do everything in its might to tackle the problems head on and that ultimately the Fed would deliver.

It is easy to see why some experts say today’s situation post the Bear Stearns bail out is similar.

Viewed from their perspective, investors have taken a positive approach to developments and what lies ahead: instead of looking for reasons to sell and to remain on the sidelines, they have started to look around and search for longer term value. And they are willing to look beyond the fact that things are likely to get worse before they will get better.

Apparently, that’s exactly what happened back then in the aftermath of the Savings and Loans crisis. Similar to the present situation, securities analysts were hopelessly behind the curve with their earnings forecasts, but investors simply ignored the fact that corporate earnings were about to take a dive. They concentrated on what would come after the dip in earnings instead.

As such it should well be possible that the share market surges to new highs while corporate earnings continue to deteriorate. As a matter of comparison, the US share market bottomed in October 1990, but US corporate earnings continued to fall until well into 1991, or so the story goes.

So far all this seems pretty similar to what we are dealing with today, including the fact the US housing market has yet to find a bottom, and is likely to require a long time still before the next sustainable recovery can kick in (back then the misery went on for five more years).

No doubt, back then banking stocks would have been cheaply priced and the first to bounce in the lead up to the overall market recovery. That’s exactly what has happened over the past weeks, even before Westpac ((WBC)) and St George Bank’s ((SGB)) announced merger plans injected an extra dose of optimism into the Australian banking sector.

As such, the recent recovery of Australian banking stocks has come much sooner than most market strategists would have predicted (the recovery certainly has come much sooner than I personally would have thought possible), however, further analysis shows this revival does make sense, and not only because investors are willing to take a positive approach to what lies ahead.

I believe the recent revival for banking stocks has been as swift and as powerful as it has been because it stems from both bears and bulls buying into Australian banking shares. As such it is difficult to predict how far this revival can stretch.

Is it possible Australian banks are back on their way towards previous price-earnings multiples? I believe such a scenario cannot be dismissed, even though many experts might argue this wouldn’t make sense given the many headwinds that still lie ahead for the sector.

The irony is, however, increased attractiveness of owning Australian banks makes perfect sense from a relative point of view. Yes, Australian banks will be facing some tough times ahead, and fiscal 2009 might well turn out worse than what we’ve seen so far, but the outlook for many other companies in the Australian share market is likely to be worse.

Consider the recent projections by the Reserve Bank of Australia. Not only does the RBA anticipate that inflation will remain a tangible problem in Australia until 2010, the RBA also foresees three calendar years of below trend GDP growth. As we are not even half way through the first year, that seems like an awful long time if you are currently owner of shares in Harvey Norman ((HVN)) or JB Hi-Fi ((JBH)).

Equally, looking back to what happened in the nineties raises a similar relative attraction for banking shares. After peaking in 1989, and reaching a second lower peak in 1990, the Australian share market hit bottom in late 1990. Once the market recovered from its lows, it subsequently languished in a sideways trading pattern (as the Australian economy went through a rough patch) only to dive again two years later. Only after this second fall did the market commence a recovery that would turn out sustainable.

(Everyone can observe this pattern by going to Yahoo! Finance and request a chart for the All Ordinaries index for the maximum time period possible).

Regardless of whether one has a positive or a not so positive view on bank earnings in the years ahead, fact remains the banks have first come under the market’s scrutiny because of the global credit crisis. As a result of this, current market forecasts for the banks are arguably less off the mark than for most other sectors.

As companies will start issuing profit warnings, as the economic reality of a downturn in Australia and elsewhere will become increasingly visible, this is bound to further raise the relative attractiveness of bank dividends.

Whether you are hoping the next bull market has already started, or you are preparing for several tough years ahead for the local economy and share market, it would seem all roads lead to the banks these days.

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