Rudi On Thursday

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(This story was originally published on Wednesday, February 3, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

I have not yet joined the world’s doom and gloom forecasters, and I certainly do not have the intention to do so today.

Firstly, I do not believe that the future can be read from price charts. I do not believe the future is set and already determined. Whatever the future might bring will be the net result of all relevant actions and responses between yesterday and then. As such, what we call “the future” is a constantly evolving process.

I don’t believe the future can be read from the past either. If the past shows us anything it is that things are always different, even if they repeat themselves. The past also shows us it is far easier to look back and see things coming “in advance” then it is in real time.

Over the past weeks I have been pointing to the fact that trendline after trendline has been broken. In Chinese equities. In oil. In base metals. In many equity indices across the globe. In FX crosses (especially those involving the yen, the USD and the Aussie). In all major commodity indices.

Surely, anyone with an inquisitive mind will have asked by now: what exactly is happening?

A trend has come to an end. This has been my conclusion for the past three weeks and I certainly have seen no reason to change my conclusion. But is it the end of the uptrend, in other words: are we heading back to where we left it in March last year?

I don’t know.

I do know that similar events from the past show us that all the above mentioned assets, crosses and indices are now likely to struggle for a while, and this struggle can manifest itself in various forms: increased volatility with no net gains, side-ways movement or a new, opposite trend.

The latter could be very disappointing because, as equities and commodities were enjoying a pronounced uptrend, this would mean the opposite will be happening from now on.

Taken from a positive point of view: it could be argued that equities and crude oil have effectively been sideways-tracking since late September last year. This makes February potentially the fifth month in a row.

Back in 2003, as I have pointed out earlier, the sidetracking prior to the trend line breach only lasted for about a month, but it then lasted for nine more months after the event.

In 2007-2008 however, there was no sideways movement, that was pure carnage.

So what makes 2003 so different from that latter experience? Simple. The first one was followed up by the next bull market. The second was not.

To put it in another way: in the first case economies re-established themselves, started growing strongly and allowed demand for commodities, for products and for services to grow strongly too. Company profits followed suit, and thus share prices did so too.

In the second version everything opposite happened. No wonder share prices and prices for commodities went down.

As I pointed out in my Weekly Insights analysis this week, the same happened in 1994, when, after a strong rally in the year prior, equities and commodities peaked in January – and they never even came close to those peak levels again for the next twelve months.

Back then economies stumbled temporarily, as one would expect coming out of a severe crisis, but they continued recovering and ultimately became strong and healthy again. Thus from 1995 onwards everything went up again.

Conclusion number one: when viewed from a broader perspective, 1994 was merely a dip, a pause, a year of consolidation in a longer term uptrend. And so was 2003/04.

Problem: most investors observe and experience financial markets from a micro-perspective.

Conclusion number two: clearly, financial markets are not always following the direction of the global economy, this despite most financial experts basing their views on the global economy.

Question: what could be more important and more dominating than the recovery of the global economy?

Try the health of the financial system. Global liquidity. Future policies and regulations. These are all factors that have captured news headlines, and investors’ angst, from mid-January onwards.

Yet, despite all these grave concerns (and I haven’t even mentioned the increasing tensions between the Obama administration and China) there could be a far more simpler explanation as to why 2010 might become more of a repeat of 1994.

Market strategists at Citi in Hong Kong, Markus Rosgen and Elaine Chu, always had an inclination that year number two after an economic downturn is likely more of a subdued event – this contrary to widespread assumption that year two is still a very good one for investors. Now Rosgen and Chu have done some historical analysis, which in essence has proved their gut feel correct.

The term we are looking for is: PE contraction.

The analysis conducted by Rosgen and Chu shows that a typical scenario after the downturn is for share markets to rise strongly on rising Price-Earnings Ratios as profits are still low, but investors are hopeful these profits will rise at a later stage. In Year Two, however, higher profits do manifest themselves, but PERs fall back to lower levels.

It doesn’t take too much imagination to see that this negative change in PERs becomes a headwind, even with rising profits.

This does not mean that 2010 will by default generate a negative return for equity markets (as happened in 1994). It does mean however, that returns will be a lot less than growth in profits might indicate.

If you’re looking for reasons why PERs contract in the second year I’d say it probably has to do with the fact that by then concrete numbers start replacing hope and expectations. This is bound to put a dent in overall enthusiasm, plus central bankers are by then looking to shift into tightening mode which always puts a lid on too much exuberance too, if not through a less-accommodative bond market.

In 1994 the bond market turned into the evil-doer.

Citi’s analysis, which I am prepared to adopt myself, fits in with the macro-views at GaveKal, where market strategists this week reminded investors that bull markets typically progress in three phases:

1.) in phase one everything goes up. No really, especially the lower quality assets (“junk”) – they outperform the quality ones.

2.) in phase two markets tend to gravitate to where the growth drivers are

3.) in phase three the focus shifts towards cheap assets and value plays

We should be in phase two now, but, interestingly, remarks GaveKal, on the basis of recent market movements one would be inclined to think these growth drivers are “Western brands” more so than emerging markets or commodities. GaveKal likes Western brands as they represent “growth” while trading at historically cheap valuations.

First, however, we are going to see a decisive battle between the bulls and the bears in the market – between those investors who cannot believe they managed to fetch some extra BHP Billiton ((BHP)) shares below $40 this week, and those who believe they will be able to buy some at lower prices in a while from now.

Who’s going to get the upper hand?

My bet is on the bears. Firstly because we had too much exuberance in late December-early January and that always takes a while longer to completely play out. I believe, for example, that base metals, and copper in particular, still have struggles left and oil’s best hope would seem to be further range-trading, for now. But also because many observant market watchers are pointing at weak underlying equity market dynamics, and not just in Australia.

The number of stocks rising is gradually being outnumbered by the number of decliners. Market volumes during up days (like Tuesday and Wednesday in Australia) are much, much lower than on down days. This has traditionally always been a warning signal.

In addition, I don’t think portfolio-readjustments across the globe have run their course just yet. Remember, last year every investor and his grandmother went short US dollar and long risk assets. This year’s process of re-adjustment is not over yet.

There are still plenty of technical chartists out there who warn about weak internals, broken support levels and lower targets that will be put to a test.

Some market watchers have pointed at the decline in overall liquidity as an explanation for the general retreat in investor risk appetite last month. Analysts at GaveKal however, have measured that overall velocity is back into negative territory again. Market analysts with an international spectrum report upgrades to earnings growth are petering out across the globe.

Above all, we are likely to see some dodgy economic news coming through, because China and India are stepping on the brakes and we are still in a particularly vulnerable and volatile phase of the economic recovery.

Consider, for example, the following admission I picked up from Obama advisor Larry Summers at Davos last week: the US is experiencing a “statistical recovery and a human recession”.

My best advice is thus: follow the footsteps of the RBA this week; gentle and cautious, while observing what is yet to come, is probably best at this point in time.

As long as the optimists and the value-seekers don’t give up, we’ll see plenty of rallies after the selling.

With these thoughts I leave you all,

Till next week!

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

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