Rudi On Thursday

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

(This story was originally published on Wednesday March 25, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

Time to once again stick my neck out: I predict the current rally will come to an end around 3780, the highest level thus far this year for the S&P/ASX200 index and last seen in the second week of January.

I am well aware that my prediction appears at odds with current market momentum and investor optimism, as well as with the favourable seasonal pattern I have referred to on numerous occasions since early this month, but I think all of those supportive factors are gradually being outweighed by the relentless buying that’s going on. Everything has a price, even in a bear market.

If my information is correct stockbrokers around Australia have seen a remarkable uptick in share market interest and investment activity from their clientele this week. That’s what two weeks of rising share prices do to the human spirit. However, after a rise of 15% and with the rally now in its third straight week, one would have to question the logic of still jumping on board this fast moving share market express.

Another theory that is going around the traps is that many fund managers have equally been taken by surprise by the strong rally since the second week of March. (This theory seems to have merit as I have come across similar indications). Are these fund managers now equally keeping the current rally alive in order to avoid having missed out?

Last week I used my weekly editorial to highlight that share prices and consensus price targets for bank shares in Australia were converging; usually a sign that the banking sector, and the share market in general, is becoming topsy turvy. I suggested a pause would seem but appropriate. This pause has lasted exactly one day.

Today, bank stocks have been further fuelled by a “revelation” at a US conference by ANZ management that operationally everything runs like a well-oiled machine. The bank is also looking into buying RBS operations in Asia. Firstly, I believe the theme of strong underlying operational performances for banks in Australia is what partially has kept this rally going: talk to anyone in the industry and they’ll tell you the banks are using the current tough environment to their own benefit. Their profit margins are actually increasing.

As more and more investors, both big and small, have picked up on this over the past weeks, the banks have staged a remarkable rally. Add the latest relief-programs in the US and it is not difficult to see why one well-read commentator is exclaiming every day now that banking stocks in Australia have seen their bottom in this cycle.

While this may be true, and there’s certainly a clear and acceptable logic behind this call, investors should not forget that they can still lose money by buying in at too high levels. In my Weekly Analysis this week, I suggested it was likely securities analysts would re-assess their valuations and price targets for banking stocks in the weeks ahead. This is likely to result in a catch-up lift to their current targets. The key question remains, however: will these revised targets go further than where current share prices already are?

Consider that after today’s stellar follow-through, only one major stockbroker in the FNArena universe still has a twelve month price target above the current price for Commonwealth Bank ((CBA)) shares. It’s BA-Merrill Lynch and only just.

The lowest target, set by UBS, which is arguably too low, is currently 27% below the share price.

The situation is not that different for Westpac ((WBC)); two targets left to overtake, though admittedly at 4.1% and 5.6% respectively above today’s share price.

A few percent more -at the max- I’d say, and current investor exuberance will have completely maxed out what can potentially be left at the bottom of the valuation barrel for Australian banks. Valuation doesn’t count for much in a bear market. It’s one of the key statements in my presentations about the bear market (which have formed the basis for our DVD “Dealing with the Bear”), but I simply fail to see how this rally could possibly extend another 35%-or so (as some chartists have been suggesting).

Note that the current rally takes place against a background of ongoing falling expectations for economic growth and corporate earnings. Martin Feldstein, Harvard professor and a key advisor to the Obama administration, said in an interview with Reuters released today the US recession will last “well into 2010” and the current government stimulus is expected to offset only a “relatively small piece” of the likely drop in spending, exports and construction.

It is at times like these we don’t want to hear about these things, and we prefer to cast them aside, but that doesn’t necessarily make them go away.

(Equally, there are negative developments in Eastern Europe nobody is paying attention to).

Another observation I made this week further strengthens my view: securities analysts have started downgrading stocks that have surpassed their price targets (not necessarily banks, though Macquarie Group ((MQG)) received two downgrades today). What this means is that structural headwinds are building for this rally, and they will only become stronger as shares continue moving to higher prices.

Here’s something you could have all picked up yourself (as the chart is included in every Weekly Insights email): since the February results season, which unsurprisingly generated more recommendation downgrades than upgrades, analysts have been issuing more upgrades than downgrades in the first two weeks of March.

Last week, however, downgrades and upgrades were in balance. This week, and for the first time this month, recommendation downgrades have started to outnumber upgrades. And the process seems to have accelerated over the past two days.

It’s getting topsy turvy out there and I don’t seem to be the only one who thinks so.

James Hardie ((JHX)) shares are at present nearly 9% above their average price target. Shares of Perpetual ((PPT)) are at a premium of about 12%.

Sure, many other stocks still have a large gap to fill, but what are the chances if the market leading banks, and BHP Billiton ((BHP)), and so many others no longer seem to have such luxury?

It’s probably no coincidence share markets are enjoying their best time in a long while in the absence of any meaningful economic or corporate data releases. That too will change in April when US companies will start releasing their quarterly updates. And on April 1 US investors will be able to digest the latest indications from the labour market and how the manufacturing sector is faring. That’ll be the real test; investor optimism versus economic reality.

If you think about it: the response by the markets in case of further disappointments will largely determine whether the current rally is part of a bottoming process, or not.

With these thoughts I leave you all for this week,

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by Andrew, Greg, Chris, Grahame, George, Joyce and Pat)

P.S. Chart for this week: investor risk appetite is back at levels last seen in November 2008 and November 2007. Standard Chartered’s gauge seems to indicate there’s still a bit of room left before we’re at similar heights as back in November 2007, but not much.

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