Beyond The Relief Rally

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

This story was first published two days ago in the form of an email sent to paying members.

"The share market consists of one group of people who fail to learn from history and another group of people who simply don't how how to read or interpret history." (*)

By Rudi Filapek-Vandyck, Editor FNArena

It was always a near 100% guarantee that share markets across the globe and commodities would rally strongly once the selling pressure would abate. The problems in Greece haven't lasted long enough to damage market expectations for 2011, and thus many stocks look excellent value on FY11 projections.

To illustrate this from an Australian context: global resources giants BHP Billiton ((BHP)) and Rio Tinto ((RIO)) were all of a sudden trading on FY11 multiples of 8, while Australian bank shares (Big Four) had fallen to up to 20% below their average price target.

Add a continuous undercurrent of solid looking economic data in the US and most places elsewhere and it is difficult to see how investors would be able to resist the lure of truly cheap looking high quality share prices. Once the obvious valuation gaps have been filled however, the same headwinds that were forming before mid-April will still exist.

Over the past two weeks I have been highlighting that earnings expectations for the main Australian-listed companies have started to go backwards. April marks the reversal and May has, thus far, simply brought us continuation. Though it must be noted Iress ((IRE)) and Telecom New Zealand ((TEL)) were noticeable exceptions on Monday.

Economic data in Australia have been rather soft lately, and the RBA remains in tightening mode, albeit with an anticipated pause first. China too is expected to start generating signals soon that government policies are having an impact. In other words: Chinese data should be close or even past their peak for this year.

None of this suggests risk assets cannot deliver positive returns over the quarters ahead, even though most share markets have now fallen back in negative territory for this year.

However, the fact that equities have struggled to accumulate positive returns after more than four months, and with economic growth poised to start slowing down from here on, it is hard to see where those fierce rallies should come from that some market bulls are predicting – other than after a pullback like we've experienced in January and now again in April.

All of the above is symbolised by the US ISM Manufacturing report for April. For the first time since 2004, the index has now surged above 60. This is a truly remarkable feat, not just because of the speed of the recovery following one of the most remarkable crises in history, but because an ISM reading above 60 is a rare event in itself.

In the past two decades, only the years 2003 and 2004 have generated readings above 60. The reason why such strong readings are rare has probably to do with the fact that the index starts from scratch each month and thus very strong momentum is required against the previous month (and not against twelve months earlier which can be much easier following a deep crisis).

Above all, however, an ISM reading above 60 signals a peak in growth momentum is now likely upon us. The future should now bring a slowdown, though we don't know as yet as to how slow this slowdown will turn out to be. In the aforementioned 2003-2004 period, the index remained above 60 from November 2003 through June 2004 (with one reading of 59.9 for February in between). This is not the only time in history this has occurred.

Ultimately, however, momentum wanes and share markets tend to respond accordingly. This is especially the case since share markets try to lead both the build up in momentum as well as the slow down.

I have written in the past about how market strategists use the US ISM as a contrarian indicator. For those subscribers who have missed my previous update, there is a reference at the bottom of today's story.

It is probably a good idea to point out that a peak in the US ISM does not necessarily imply that the future can only hold negative returns on equities and commodities from here on. History shows investment returns tend to be far more modest after the US ISM peaks above 60, but modest retuns can still be positive returns.

Recently, market strategists at BTIG conducted their own research into the matter, and on their calculations:

1.) The average performance of US equities after 12 months following the first ISM cross above 60 is 4.28%; over the two years following the event it is 11.92%

2.) Post-1970 returns are notably weaker than pre-1970 returns

3.) US equities tend to rally strongly in the year leading up to the ISM cross above 60

Note: the third conclusion suggests share markets tend to price in some of the upside prior to momentum reaching a peak, after which a period of consolidation becomes inevitable, while headwinds build on slowing momentum.

Sounds a lot like 2010, doesn't it?

Here are the previous five references (all calculations done by BTIG), note that 1987 is oft regarded non-representative by many an economist:

– date ISM first crossed above 60: 31/12/2003 – return year prior: 26.38% – return year after: 8.99% – return two years after: 12.26%

– date: 30/09/1987 – return year prior: -23.23% – return year after: -15.51% – return two years after: 8.49%

– date: 29/07/1983 – return year prior: 51.80% – return year after: -7.32% – return two years after: 17.45%

– date: 31/05/1978 – return year prior: 1.22% – return year after: 1.84% – return two years after: 14.34%

– date: 30/01/1976 – return year prior: 31.02% – return year after: 1.16% – return two years after: -11.51%

Note that BTIG sees strong similarities between our current experience (US equities rallied 37% prior) and what happened back in 1983 and 1976. In both cases the strong rally prior to the peak above 60 for the US ISM was followed by either a negative result (1983) or a barely positive result (1976).

Note also that economists at JP Morgan compile a global ISM index these days. Their most recent update for April showed a modest fall from March, suggesting that even if we concentrate on the world instead of the US, the principle might still be the same.

Subscribers can access my previous story on the US ISM Index, published in March this year, titled "Why A Global Peak Could Be Near" on the FNArena website under Rudi's Views.

Subscribers may also want to read: "History Suggests No Great Return For Year Zero", December 2009.

Note all consensus forecasts and Price-Earnings ratios are instantly updated on the FNArena website and 24/24 available to subscribers.

(*) The quote on top of today's story is mine. Harsh? Maybe, but true nevertheless.

This story was originally written on Monday, May 11, 2010. It was first published in the form of an email sent to paying subscribers on the day.

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