FYI | May 31 2006
Confusion seems rife since we made our Bear/Bull Indicator public last Friday. I thought this would probably be the right time to provide the readers and subscribers to FN Arena with some explanations.
I still intend to write some explanatory text about the how and why behind the indicator and it will be permanently available on the website, hopefully soon. It’s just that sometimes time is not on our side, and this week is one of those times.
To understand the underlying market sentiment that is measured by our indicator, we have to go back to the meaning of the broker recommendations that form the basis of what we measure with our indicator.
Broker recommendations are seldom issued for a time frame shorter than six months, and mostly for a period of twelve months. The same principle applies to the price targets that often go with them.
Having said that we have always argued there is a large portion of overall market sentiment that comes with these recommendations. In times of doom and gloom, securities analysts tend to listen more to the negative and the cautious side of the human brain. At times when everything seems bright and sunny the opposite happens.
So are we experiencing a period of euphoria in analyst expectations and projections?
That is a difficult question to answer. Fact is, earnings expectations in general are still moving upwards, and that is particularly the case for energy and commodity related companies, less so for the rest of the market.
Another fact is the amount of Buy recommendations has probably never been as high as it is today. The number of Buys currently stands at 37% of the total while the amount of Sells is still above 13%.
This has forced the amount of Neutral recommendations below half of the total. The number dived below 50% on Monday and has remained below it ever since.
Let’s look at the movement behind these figures: 38 recommendation upgrades and 11 downgrades over the past five trading days. As we reported earlier this week, the majority of these recommendation upgrades went to companies in the energy and mining sectors.
One criticism that is often addressed at the community of securities experts is that while setting price targets and giving investment recommendations short term considerations are seldom taken into account. Let’s leave that discussion for another time and focus on what lies at the heart of most of these recommendations: intrinsic value.
What our Bear/Bull Indicator tells us today is that Australian securities analysts believe there is still a wealth of intrinsic value in the Australian share market.
Can equities go down further from here? You bet they can.
But when the only answer to increased volatility and declining share prices is the issuing of more and more Buy recommendations, the logical conclusion to draw is this share market will rise again – and further. An opinion supported by the likes of AMP and Commonwealth Bank who have argued recently the market has simply let off some steam and has returned closer to fair value.
Unless, of course, we are experiencing the phenomenon of a massive brokers’ trap. As we have learned from four years of analysis, there are two ways to match future projections and reality. Either the share price rises to meet the analysts’ expectations, or the analysts revise their projections downwards.
The main theme on investors mind is now slowing economic growth. Will it impact on global demand for commodities? Will it force consumers in the US and in Australia to become more careful about what to spend and when? And will it prevent interest rates from moving up much further?
The majority of economists and strategists appear to have an optimistic view on all these questions. Predictions are for copper supply to remain tight for another two, maybe even three years. Oil is expected to remain above US$60 per barrel for a long time to come. And the US housing market should experience a soft landing similar to what happened in Australia.
No doubt, it is this optimism that is behind today’s Buy recommendations.
Realistically, I would argue we are experiencing a period of excess. Not even in the doom days of 2001, when we started our analysis, did the amount of Buy recommendations reach to current highs. In fact the amount of Neutral recommendations ran up to 59% in those days. Which proves my point: it is the mindset behind the calculations and projections that forms the base for the overall market sentiment.
Assuming the balance between Buy, Hold and Sell recommendations will revert to its mean again, which is probably around 35/53/12, there are two logical scenarios that lie in front of us.
Either share prices will rise, which will lead to less value and thus to a lower amount of Buys, which will push up the amount of Neutral recommendations (brokers don’t like Sells) – or future expectations will come down.
Scenario two will have a similar effect on the amount of Buy, Hold and Sell recommendations in the market. This scenario is not unthinkable as economic growth is slowing. In fact, time will come when slower growth will lead to lower expectations – but when?
Most experts seem to be of the view that the second scenario is some time off, yet. We’re probably talking 2007, or the second half of 2006 at the earliest.
If you’re not siding with the bears in the market, the only logical conclusion would then be that share markets should rise again, and rise higher than to where they are today.
However, it would seem that turbulence and insecurity have made their entrance in global finance in May.
History shows the gap between intrinsic value and actual share prices can extend in both ways, and for a long time.
Under a worst case scenario investors may have to wait until the final quarter when the traditional year end rally will close the valuation gap again.
Best case scenario is for the market to start picking up tomorrow.
Reality probably lies somewhere in between.
Our indicator gives you some insights in what is happening beneath the market, don’t expect it to be a divine oracle, or a pack of cards of a clairvoyant.
Your always analysing editor,
Rudi Filapek-Vandyck
(Supported by the Magnificent Three: Greg, Chris and Robert)