A Message To You, From The Banks

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

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

In the first week of May I observed how Westpac ((WBC)) shares had surged past the average price target for the bank.

History had taught me this was not a good sign. The problem with investor sentiment is, however, that one never knows how long the pendulum will swing into one direction. By the next week all the banks were trading above their average price targets.

Those who have been reading my analyses over the past few years know that whenever banks reach their average price targets I usually start making references to a pending share market correction. My confidence in this matter is predominantly based upon two key factors.

For starters, I have observed this similar pattern over the past five years now, and it has proved to be 100% accurate; every time the banks reach their targets, or exceed them, Australian banking shares are becoming too expensively priced. A retreat is to follow.

Secondly, it also makes sense from a fundamental point of view: banks are not producers of commodities. Their earnings outlook tends not to change overnight, and thus their valuations are relatively stable and predictable. Securities analysts set targets for twelve months into the future. If banks already reach these targets in advance, where else do these shares have left to go but down?

Because of the dominant representation of banks in major share indices in Australia, I always assumed (and correctly so) that what applied to the banks also applied to the Australian share market as a whole.

Come early May I was wrestling with two key questions:

1. Do the banks still represent the broader market now that the pendulum has decisively swung in favour of market dominance for resources and energy companies?

2. Could it be that rising share prices were simply pre-empting rising price targets as the results season for the banks proved to be not as bad as many had feared?

Most investors will probably agree that recent developments have put energy companies in particular even firmer in the market lead, as long as they’re not involved in uranium but in oil and natural gas instead.

As far as the second question goes, again the answer has proved to be affirmative: securities analysts did lift their earnings forecasts, valuations and price targets for the banks following the results season. In some cases quite significantly so, and that’s without including St George Bank ((SGB)) as the take-over agreement with Westpac obviously changed market dynamics for Australia’s fifth largest bank.

In addition, I observed how an overall improved risk appetite among investors had steered them back towards the relatively cheaply priced banking shares.

I would have done very well if I were still studying at university. Unfortunately, this is the share market and questions answered correctly do not necessarily lead us to the right outcome. My hesitance in May to call the next share market correction has turned out to be too cautious. (Though I did point out at the time what I explained in the first paragraphs of this story).

The S&P/ASX200 peaked (intraday) at 5980.80 on May 19, when all the banks were beyond or near their average price targets and securities analysts were frantically revising their targets upwards.

Unfortunately, this did not prevent banking shares from gradually weakening in the following two weeks.

CommBank ((CBA)) shares went from $44.95 on May 16 to $41.49 on Tuesday; ANZ ((ANZ)) shares went from $23.70 on May 12 to $20.38; Bank of Queensland ((BOQ)) shares reached $17.15 on May 13 but on Tuesday closed at $15.06. National Australia Bank ((NAB)) seemed on its way to $35 and beyond on more than one day in May, but the shares are now back below $30.

On Tuesday the S&P/ASX200 index closed at 5574.20, more than 400 points lower than where it was two weeks ago. One logical conclusion to make would thus be that my doubt has been misplaced: the banks still very much show us the direction for the broader market.

So should we get worried? I think so, yes.

Not only are investors once more increasingly growing aware of the fact that what started off the global share market correction mid last year -the international credit crisis- is far from resolved, but those with a broader view on things are now talking second phase. In other words: there is more to come still and share market investors have anticipated this by once again selling down their banking exposure.

Many financial shares overseas are again trading near their lows from the past year. In Australia, only ANZ bank is thus far within a whisker of the share price low reached in March this year.

Ominously, perhaps, is that market watchers and analysts have observed how banking stocks in the US have been breaching technical support levels and queuing up all sorts of bearish market signals and indications over the past few weeks. The most straightforward conclusion one can draw from all this is that it probably does not bode well for the immediate outlook for the sector.

But banks also remain an important epicenter for the global economy. As such it won’t be long before investors will draw the conclusion that the resurfacing of more problems inside the banking sector is not good news for global growth.

The same applies to current high oil prices. Oil may no longer be priced above US$130 per barrel, but even in the mid-US$120s, the impact on the global economy will be severe (regardless of what the oil bulls will tell you). End result: lower economic growth.

Ultimately, investors will make the connection with commodities, and the price of oil itself. Similarly to when Westpac reached its average price target, it’s very difficult to predict what and when exactly will set off this process. But it will happen.

Now you all know why it is not so difficult to see why many a technical chartist is predicting there lays another downward move in front of the share market. That move may well have started in mid-May, when banking shares exceeded price targets. Remember that one for next time. Hasn’t failed once.

Click to view our Glossary of Financial Terms