FYI | Aug 30 2010
This story was originally published on 25th August, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere.
By Rudi Filapek-Vandyck, Editor FNArena
I have long hesitated to make that one comparison, but I finally think it's time: I have seen this all before. You were there too. It was 2008. Equities were cheap, but getting cheaper by the day. Stockbrokers and financial media couldn't find enough reasons as to why equities should be the preferred destination for all the cash on the sidelines.
As it turned out, that cash on the sidelines has been piling up in government bonds, and that's still a process that is far from finished.
Since April, it seems stockbrokers and bullish market commentators have been throwing everything they could at investors who were sitting on the sidelines, from the usual “equities are cheap”, to “unmistakably long term value”, to “don't watch bonds, they're in a bubble”, to “cash on the sidelines”, to “companies are cashed up”, to “don't fight the Fed”, to whatever could possibly entice investors back into the market.
What they did not add, however, was they NEVER see a downturn coming, not even if it would take the shape of a monkey and spent a whole month on top of their office desks.
Which is why I have had, on a regular basis, the feeling that we're simply going through the same stages and the same processes as we did back in 2008. Ultimately, of course, all those “experts” and commentators will fall in line with reality again.
As colleague Greg used to say: a broken clock is correct twice per day. I haven't heard him using the expressing for a while now, but maybe it's time to start reminding ourselves?
Similar as to what happened in 2008, key trends in economic data are pointing south, and they continue doing so. What's even more important is that, after a while, market expectations adjust and forecasts are lowered. This is exactly the process we are going through right now.
In terms of US GDP growth numbers, note that at the beginning of the year economists were expecting 4% GDP growth for the second half. These estimates are now falling, and they continue falling. First it was 3%, then 2.5%, now estimates are being set at levels below 2%.
There is no guarantee these projections are now correct.
Even more important than the fact that market forecasts continue declining, is the fact that economic data continue surprising to the downside. This, I would like to emphasise, is what the present weak mindset of Mr Market is all about: despite expectations falling, economic data continue surprising to the downside, indicating that expectations overall are still too high.
I am genuinely surprised that I remain one of few market analysts only who genuinely pays attention to trends in market expectations. Well, I don't think anyone else does in Australia (?). Those who do elsewhere (as in: other countries) continue pointing out how these changes in market expectations act as a leading indicator for financial markets.
I already pointed out months ago that market expectations in Australia stopped rising in April. They have been falling since May. Is it coincidence then the share market peaked in April too?
As far as the current corporate reporting season goes, I don't think there's a more genuine indicator than stockbroker recommendation changes. Usually there is a direct relationship to rising and falling share prices and broker downgrades and upgrades of individual stocks.
I have explained this relationship many times before and there's no secret to it: most recommendations are based on valuations so the inverse relationship is logical and easy to understand.
This makes it even more remarkable what has been happening this reporting season. Despite equities moving through a tough patch, gradually falling to lower and lower levels, recommendation downgrades from the ten experts in our universe have significantly outnumbered upgrades.
This observation is so out of line with normal practice that I think this is the true message coming out of the local reporting season this August: there is, outside of the materials sector, obviously not as much value on offer as market bulls want us to believe.
Why else would securities analysts issue more downgrades on such a large scale?
This, by the way, is an observation everyone could have made who has been reading my Weekly Insights emails since July and paid attention to the balance between upgrades and downgrades as shown in one of the graphic illustrations inside the weekly email. Here are the facts:
The last time upgrades beat downgrades was in the week ending on Monday July 19, when 16 upgrades beat 15 downgrades by the slightest of margins.
Since then we have had five consecutive weeks of significantly more downgrades than upgrades:
26 July: 23 down vs 8 up
2 Aug: 25 down vs 10 up
9 Aug: 20 down vs 10 up
16 Aug: 25 down vs 15 up
23 Aug: 40 down vs 19 up
Judging by the daily numbers on Tuesday and today, it doesn't appear this trend is about to reverse, even though it has to be noted the gap between the two is closing.
The past five weeks (counting back from Monday) have thus seen 133 downgrades outnumbering 62 upgrades. In simple terms this means there have been more than 2 downgrades for every upgrade issued during this reporting season which still has about a week to go (including the two weeks when companies issued production reports and pre-releases).
Meanwhile, more downgrades than upgrades are also happening when it comes to company valuations, price targets and earnings forecasts. But as I pointed out earlier: the reporting season in February will be much more important because it will reveal how companies have performed half-way through the fiscal year, not just a few weeks.
As has historically been the case, falling forecasts and negative trending economic indicators have squeezed all exuberant (and naïve?!) optimism out of financial markets. This now causes a rapidly deteriorating technical picture.
Earlier in the week, I observed major indices in Australia, in line with major indices in the US, appear to be carving out a negative head-and-shoulders formation. As this formation has taken three months to complete (June, July and August) investors shall ignore it at their own peril.
This is another repeat of the 2008 experience. After I had made the call in early August that the “most severe correction ever in commodities” was about to take place, head-and-shoulders signals started appearing on all kinds of price charts.
I am not making a similar call this time around, but I do think the bias is firmly to the downside for the foreseeable future.
In addition, I recently wrote about the Hindenburg Omen. The first warning signal at the end of the first week of August has now been followed up by a second warning at the end of the second week, which makes it a “confirmed” signal.
According to the stats belonging to this technical indicator we now have:
77% probability of a 5% correction within the next 41 days
41% probability of a panic sell-off
25% probability of a genuine market crash
30% probability of a decline of 15% or more
To read more about the Hindenburg Omen, see "Rudi's View: The Hindenburg Omen, Scary But Unconfirmed"
Given the next two months are September and October, and against the background of all of the above, I'd say: pick your pick. But also: think twice, if not more, before you think about becoming the next hero.
P.S. Watch the Obama administration and the Federal Reserve getting more nervous by the day…
P.S. II – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.
