Rudi On Thursday

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(This story was first published on Wednesday, October 14, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

This happens about every other day: someone, somewhere mentions something about a pending correction and next thing I know I find a message in the FNArena inbox, or in Editor Direct on the website, enquiring about my view: is there going to be a major market correction?

The short answer is: not any time soon.

I standardly reply to those enquiries: there has to be a reason for financial markets to start selling off. The fact that most investors have missed out on the rally this year, and are desperately waiting for a sizeable pullback that would allow them to get into the market at more favourable prices is NOT a reason.

Negative developments in terms of economic data, geopolitical tensions, government regulation or corporate earnings could all potentially reverse the present market buoyancy, but so far none of that has appeared on our doorstep. Quite to the contrary, actually, forecasts for economic growth, for demand, for resources and for corporate earnings continue to improve and this continues to support asset prices, and investor optimism.

So far, so good.

Except, of course, that too much of a good thing ultimately ends up being negative. Just ask any child who’s been left with the cookie jar unsupervised for too long.

For Australian investors the backlash will come in the form of rising interest rates, but more so through an ever stronger Australian dollar. As I predicted a while ago, the Australian dollar will start featuring more and more in FNArena’s daily Australian Broker Call Report, and it has.

Here are two examples (out of many more) from today’s edition:

“Following a marking to market of the group’s investments and updates to the broker’s forex assumptions” (on insurer AMP ((AMP))

“Changes to the broker’s forecasts for commodity prices and exchange rates” (on Alumina Ltd ((AWC))

Outside the Australian Broker Call Report, I noticed market strategists at Macquarie have dumped blood and flu vaccine supplier CSL ((CSL)) from their Recommended Stock Portfolio. Their main motivation (as pointed out by myself too to everyone who has asked me about CSL over the months past): the Australian currency is going to weigh on profits for shareholders in Australia. The fact that most valuations and price targets set by stockbrokers are still dollars away from the present share price is unlikely going to outweigh the fact that headwinds will continue building as the AUD becomes stronger and stronger.

The danger is that market momentum for stocks such as CSL will at some point turn negative. In fact, judging by current trends in FX crosses and earnings updates by securities analysts, this process has likely already started. About one month ago, CSL shares were trading between $33-34. They are below $32 now. The share market as a whole is up.

Equally important: broker price targets are now in decline, and so are their EPS forecasts. At present, CSL is forecast to improve its earnings per share by some 13% this financial year and by some 15% in fiscal 2011. The problem is: these forecasts were slightly higher prior to October.

EPS forecasts for BHP Billiton ((BHP)), to name but one opposite example, are still on the rise. There’s a divergence happening in the share market. The key denominator is the Australian dollar.

What goes for CSL goes for many other exporters in the Australian share market: soon the trend in earnings forecasts will turn negative, if this isn’t already the case. Many of the victims are among stocks loosely known in Australia as “defensives”, including most healthcare stocks.

Many of these stocks have only partially participated in the rally since March (or not at all).

Key in the outlook for Australian interest rates, and for the Australian dollar, and thus for present market momentum in the Australian share market will be the strength of the economic recovery in the months ahead.

In case of disappointment we won’t see the RBA raising too many more times just yet, and the Australian dollar will fall well short of parity with the greenback. In case of grave disappointment we could see the RBA holding off on further rate hikes, the AUD back at US60c and the share market in (possibly severe) correction mode. Stocks like CSL that are now gradually falling out of favour would instantly become tomorrow’s bargains.

However, if anything, says a growing queue of market strategists, the odds increasingly seem to be falling in favour of growth surprising to the upside for the quarters ahead. It is this growing market confidence that continues to push the US dollar down, and the Aussie, gold, crude oil, base metals and equity markets higher.

It is against this background that I am responding to questions like “Dear editor, do you think there will be a correction? If so, when do you think it will happen and how far do you think the market might fall?”

Now consider the opening paragraph of the latest market update by strategists at Macquarie, released on Tuesday morning:

“A very rapid economic recovery is underway in Australia. It would not surprise us to see GDP growth approach 6% in 1H 2010. In this context, it is disturbing to see a still-large underestimation of this recovery by the authorities and some investors. The chances of an ongoing expansionary public fiscal stance forcing an overly large interest rate tightening response are rapidly rising. We expect this in turn would likely force the AUD to very high and very uncomfortable levels for much of corporate Australia.”

In other words: if investors worry about a correction, they should do so because most people are still focused on the economic carnage that took equity markets to a decade low in March, while in the meantime, the exact opposite seems to be happening in the real world.

Maybe this is an appropriate time to remind you all about what I wrote last week: both disappointing growth and surprisingly strong growth are not good scenarios for the share market in the year ahead. It would be best if economic growth were to recover at a slow and gradual pace.

Don’t bet on it, say market strategists at Macquarie. The economy is about to bolt out of the gates, fuelled by government stimulus, low interest rates and China. Already, says Macquarie, economic indicators such as consumer confidence, housing approvals, house auction clearance rates, retail sales, engineering construction approvals and government spending are at levels usually consistent with GDP growth at around 4%.

Macquarie strategists therefore have no hesitation about what investors in the Australian share market should do: increase risk – forget about going defensive. Macquarie’s Recommended Stock Portfolio for the year ahead has only one defensive stock in it, and only because the broker feels compelled to have at least one such representative in its portfolio, at well below index-weight.

As stated above, Macquarie has now dumped CSL and replaced it with Coca-Cola Amatil ((CCL)), who might well benefit from a stronger Aussie dollar via cheaper input prices.

Macquarie’s Recommended Stock Portfolio shows an overweight position in energy stocks (including WorleyParsons ((WOR)), a slight overweight position in mining companies (BHP Billiton, of course, accompanied by OZ Minerals ((OZL)) and Rio Tinto ((RIO)), a larger overweight position in banks, but above all a very, very significant overweight position in cyclical industrial companies.

Macquarie’s favourites in the latter segment include Toll Holdings ((TOL)), News Corp ((NWS)), Wesfarmers ((WES)), James Hardie ((JHX)) and Incitec Pivot ((IPL)) plus the consumer leveraged plays Harvey Norman ((HVN)), David Jones ((DJS)) and Billabong ((BBG)).

The strategists note, along the way, that banks are poised to gain extra benefit from a better overall environment for wealth managers and for financial markets in general. One way to play this theme is through smaller, more leveraged plays such as Platinum Asset Management ((PTM)), say the strategists.

If Macquarie is correct, the Australian dollar will become a major factor for the market in the months ahead. Consider this: most stockbrokers have been working off AUD estimates in the high US$0.70-to-low-US$0.80s. These AUD forecasts are now being pushed up to low-to-mid US$0.80s.

The Australian dollar has been trading above US$0.90 since last week. JP Morgan resources analysts also updated their projections this week. Their new AUD forecast for calendar 2010 is just shy of US$0.93 (from US$0.80 prior). JP Morgan doesn’t have to be correct, but it does give us all an idea about what might be coming just yet.

BA-Merrill Lynch quant expert Nigel Tupper agrees with Macquarie that it increasingly appears the world recovery is coming in a V-shape, and a strong one too. If this trend continues and proves correct, reports Tupper, history shows equity markets should perform well in the year ahead.

Investors looking for maximum leverage should opt for small size, momentum, risk, value and cyclical growth reports Tupper (this on the basis of historical references).

Only two Australian companies made it to BA-ML’s international portfolio of “Boosters” (which are, in essence, stocks believed to outperform in a V-shaped environment). Those two are Paladin Energy ((PDN)) and Arrow Energy ((AOE)).

Tupper’s Australian portfolio of “Boosters” also includes Asciano ((AIO)), Ausenco ((AAX)), Envestra ((ENV)), Fortescue Metals ((FMG)), Macarthur Coal ((MCC)), Minara Resources ((MRE)), Mount Gibson Iron ((MGX)) and Western Areas ((WSA)).

It has to be noted though, and as reported in Monday’s Weekly Insights (see “What Bulls And Bears Have In Common”, Rudi’s Views on the FNArena website), market strategists at BA-Merrill Lynch are not equally in love with miners and other resources-leveraged companies as quant expert Tupper. Their market strategists believe prices for commodities have been over-inflated this year, and this will have negative repercussions next year.

Those same BA-ML market strategists believe there are still opportunities for investors in the transport sector, among media companies and in the agriculture sector (including Incitec Pivot), as these sectors have not yet fully caught up with the V-recovery theme. In addition, investors have also overlooked some obvious yield opportunities, such as among gaming stocks and some infrastructure-plays, say the strategists.

I already wrote it on Monday: (nearly) everybody loves the banks. Even the bears at Morgan Stanley have now upgraded the sector to Neutral. Analysts at RBS believe the upcoming results season will simply deliver more good news, while speculating at least one CEO will call the peak of the bad debt cycle – if proven true there should be little doubt this will trigger further positive momentum for the sector.

Those who have been reading my editorials and analyses this year know I have been pointing to the direction of Australia’s major banks for many months now. I have repeated this view during my recent presentations across the country. I am happy to confirm -once again- I believe Australian banks remain among the best opportunities money can buy in the share market for longer term oriented investors.

Still.

(For more info and explanation: see all the stories about the banks I have written earlier this year).

With these thoughts I leave you all this week,

Till next week!

Your editor,

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

P.S. I – Contrary to normal practice, this week’s editorial was written on Tuesday afternoon. This was due to other commitments that will interfere with my normal schedule on Wednesday this week.

P.S. II – 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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