Rudi On Thursday

This story features BHP GROUP LIMITED. For more info SHARE ANALYSIS: BHP

(This story was originally published on September 23, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

A few commentators, quite a few actually, have started to compare this year’s investor behaviour with what happened in 2007 when equity markets, despite two sell-offs -one in late February and one in mid-August- continued to surge to new highs. Take away the sell-offs and compare the market’s forward looking Price-Earnings multiples – doesn’t today look eerily similar?

Yes, it does, and there certainly are a few comments correctly being made about the market’s inability to take a breather that lasts longer than a day or two in what has grown into a seven-month long rally – and who’s going to guarantee all this will stop shortly?

I have indicated earlier that I do not agree with these assessments. Well, in fact I do, but the reason why the share market is trading at similarly elevated forward looking earnings multiples is because investors try to look beyond the trough in earnings, which should be fiscal 2010, and thus they are more inclined to focus on what is likely to happen in FY11 and how that impacts on equity valuations today.

When I look at the share market, and this has been going on for a few months now, I casually overlook anything in relationship to FY10. This is why I don’t really care when Australian banks are on multiples of 15.5 and higher, or when BHP Billiton’s ((BHP)) multiple exceeds 20. Banks should continue profiting from a less dire economic situation overall through diminishing bad debt provisions, so they continue to look good value on FY11 metrics plus they come with healthy dividend yields. However, when BHP’s FY11 multiple hits 14-something I start paying attention.

First observation: you won’t find too many stockbrokers, fund managers or market commentators that put BHP shares on such a high multiple. Most work off their own currency forecasts and would yet have to catch up with the present strength in the Australian dollar, with the currency almost hitting US88c today.

That is fine under most circumstances. Stockbrokers and market commentators tend to neglect the impact of currencies on company profits and asset valuations, officially because “nobody can accurately predict currency movements”. This, again, is fine under most circumstances.

But, as I argued in this week’s Weekly Insights (see “Fewer Bargains, But No Bubble” on the website), if we take today’s AUD and use that value to determine what Australian investors are paying for BHP’s prospective earnings per share in USD, then the PE ratio blows out to above 14 on FY11 consensus forecasts. This should make everyone a bit more cautious, regardless whether we are in the September-October period or not, and regardless of all the expert calls for an “overdue” market retreat.

Let me first take a step back and zoom in on what really is supporting this market: rising earnings forecasts.

Some sceptical commentators have pointed out earnings expectations for US companies had been scaled back by 30% between early 2009 and mid-year. Only then did companies manage to convincingly beat expectations, which provided equity markets with the support they needed to continue the March rally. As you would expect, these commentators also use this as proof that investors should not rely on market expectations because they are bound to be proven incorrect.

I think this type of criticism misses the point. If investors were to take such an attitude they would never invest in anything. Have property forecasts in Australia over the past years proved correct? Do political forecasters ever get it right ahead of elections?

It is far better to understand how the share market works. When earnings expectations rise, shares in become companies cheaper by default . It also feeds enthusiasm, optimism and hope. We all want to be part of something that appears to be improving, it’s our nature (and rightfully so, because once something is no longer improving who knows how deep the bottom lies?)

A recent analysis by Citigroup showed that market expectations bottomed out around February-March. A few weeks later they started rising and they have been rising ever since. Market expectations are still rising this week. Consider, for instance, that when I wrote the Weekly Insights on Monday BHP shares were trading only a smidgen higher, and the Australian dollar was lower, yet the implied FY11 multiple was higher than today’s.

This automatically implies that earnings expectations for BHP Billiton are still rising (and I can confirm they have increased further this week), which means BHP shares are still becoming more attractive by the day.

Citi’s research suggests the market has risen so far and for so long because earnings expectations have too. I believe this is probably true, as I look at the market in a similar manner: what is happening underneath it? Since April-May earnings expectations have consistently been on the rise. Is it a coincidence that equity prices have done the same?

Time to flash back to 2007. In July of that year, just before the results season in Australia, I wrote an analysis about how a stronger Australian dollar was gradually eating into the market’s future potential. Not only does a stronger AUD make Australian made products harder to sell in overseas markets, but shareholders of companies who sell a lot in foreign countries, and then have to translate those revenues and profits back in Aussie dollars, will be negatively impacted as well.

Now here is a comparison with 2007 I can completely lend my support to: the same is happening right now. And similar to 2007, stockbrokers and investors are neglecting the negative impact of the Australian currency, probably because “nobody can accurately predict currencies”.

Yet, I can report that in addition to rising share prices, supported by rising earnings expectations, forecasts for the Aussie dollar have equally risen. This threesome cannot co-exist indefinitely. At some point earnings expectations will find it hard to rise further and from that moment stockbrokers will start updating their currency values… it may well be that from that point onwards the share prices of Australian exporters will have to take a step back, or two – depending on how high valuations have risen and how deep the new currency values will cut into projected earnings.

We are probably still at an early stage of this process. This week, for the first time in my daily observations, I spotted pull backs in earnings and ratings in the Australian Broker Call Report on the basis of updated currency values. I think this is increasingly going to feature in stockbroker updates from here onwards.

It may well be true that “nobody is able to accurately predict currencies”, but if there is one observation to be made it is that the world does not like the US dollar, and that is without the slightest doubt an understatement. I read a report this week that the Chinese government has started to promote silver as an investment alternative to its citizens. And that’s just one example.

The USD itself does not like the economic recovery. That’s another easy observation to make. Economic forecasts continue to improve and there seems to be a general consensus building that the next two to four quarters are likely to generate positive, upbeat results in the US and elsewhere. This is partly why the gold-community is all fired up again, because if this year’s trend has shown one thing it is that improving economies, rising profits (expectations) and rising share markets go hand-in-hand with a declining US dollar.

Enter a stronger Aussie dollar.

Quite a number of market specialists are of the view that commodity prices have run too fast, too far. The Baltic Freight Index is well off its highs, and I don’t mean the peak in 2008, I refer to its peak in June. LME inventories are rising and Chinese imports are in decline. Yet the prices of oil, copper and zinc all remain near year-highs. The answer everybody’s looking for is, of course, a weakening US dollar.

How long can this go on? Judging by the present trends and correlations this could yet go on for many more months.

One problem is, however, that sooner or later, investors (and companies) in other currencies have to face the fact that currency depreciation is not a one-way street. See above.

Problem number two is when assets decouple from their underlying market fundamentals and rise further on currency movements, what will happen then when this support falls away?

This is why some market experts are toying with the possibility of increased volatility in commodity and equity markets from here on – asset prices have run hard and high plus going short the USD is looking like a bet that simply cannot fail. Those who have been long enough in the market know these are the ingredients for sharp declines and corrections.

Dennis Gartman, whose decades of hands-on market experience I greatly admire, always talks about a sloop (boat) wherein everybody leans on one side. From the moment the last person joins the others the sloop will turnover and people fall overboard, allowing the sloop to regain its balance. Markets operate via the same basic principles.

This is why not everyone is convinced that everything will simply remain as it is in the months ahead. At face value, one has to acknowledge better looking economies and a weaker US dollar seem the most logical outcome to expect on, let’s say, a six month horizon. But I’d be surprised if we don’t see some sharp counter-movements between now and then.

Also, it’ll be interesting to see how long earnings expectations can continue rising and whether markets will pay attention from the moment they no longer do. Back in 2007 I had been pointing at the negative impact of the Aussie dollar on earnings projections for months, but the share market simply ignored it and kept on reaching out for new highs. That’s when you know the market really is in an unsustainable bubble.

Despite the comparisons being made between today and back in 2007, it should be clear we are in nowhere near a similar situation. Well, not yet anyway.

With these thoughts I leave you all this week,

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always supported by the Ab Fab team at FNArena)

P.S. I  – Translating foreign currency profits for shareholders in Australia remains de facto a flawed exercise, starting with the question: what do we take as our benchmark? Let’s stick with BHP Billiton on this matter. As every subscriber can see through Stock Analysis (on the FNArena website) if we take today’s AUD/USD value of 87.47c as our guide, then BHP shares at $38.35 are trading on 14.2 times projected FY11 EPS. However, if we take the average AUD/USD value from the year past as our guide then those same shares are only trading on a PER of 11.9 (FY11).

If we apply a multiple of 14.5 on the second scenario, BHP shares could easily appreciate to $47-$48 per share – or close to their all time high. But for this to happen in a fundamentally sound manner the AUD/USD cross will need to repeat the pattern of the past year, or further earnings upgrades will have to be bigger than further AUD appreciation. Don’t forget the company can also still announce a large share buy-back, which could effectively achieve the same thing.

P.S. II – A special mention goes out to David Roche, ex-Morgan Stanley and nowadays Global Strategist at Independent Strategy. When asked on CNBC what shape the coming US economic recovery would have -a V, W, U or a square root- Roche answered it will have the shape of a toilet.

Readers who attended my presentation in March, or have viewed the DVD that comes with a paid subscription to FNArena these days, will have picked up that I tend to make a comparison with a soup plate, which is in essence an extended U-shape.

Roche, in essence, shares my view, but by using a toilet as his image of reference he is also showing his view on what’s happening inside the US government and inside US banks and the US economy.

P.S. III – Analysts at Morgan Stanley recently updated their views on the oil market and it is their view that supply and demand dynamics are poised to return to the situation we witnessed between late 2007 and mid-2008: tight. The analysts see a similar tightness re-appearing at some point in 2012 and it is their view that the market will only grow tighter in the subsequent years.

In case you wondered: Morgan Stanley’s average price forecast for 2012 has been raised to US$105/bbl (WTI). The main premise underlying these projections is that global oil demand will start rising again as economic recovery gains pace. Certainly, the chart below (released by Credit Suisse this week) lends support to such a scenario. That’s all I am going to say about oil right now.

(In case you are reading this story through a third party channel and you cannot view the chart, I apologise – technical limitations are to blame).

P.S. IV – All paying members at FNArena are being reminded they can set an email alert for my editorials. Go to Portfolio and Alerts in the Cockpit and tick the box in front of Rudi On Thursday. You will receive an email alert every time a new editorial has been published on the website.

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