FYI | Nov 15 2006
The market is still not expensive. The market is overvalued.
As is usually the case when the local share market reaches a new record high, the event opens up a public debate about whether the market has reached a peak or whether there’s further upside still.
November 2006 has not been the exception to the rule with the first event, a few days ago, almost immediately followed by the second.
Those readers who have made the habit of reading my Weekly Analyses will have picked up that I have been asking the same question over the past few weeks. My analysis this week revealed a widening gap between broker recommendations and stock valuations/price targets.
A question I left unanswered when concluding this week’s Analysis was: in case of apparent contradiction between Buy recommendations and dismal upside according to forward looking price targets – which side do you choose?
(I know, in theory, such a big divergence should not be possible, but let’s leave that matter for another time.)
Personally, I’d choose valuation, thus price targets, above recommendations. Every time.
It’s a fool’s game trying to pinpoint the exact moment when the market is going to move into reverse. Anyone who has been in the market long enough, or has been following it, knows this. However, following on from my analysis and observations over the past few weeks, I think a warning seems warranted at this point in time.
Markets can go up and down, catch a train, fall into a spin, or crash and bounce at any given point –that is the nature of the beast we’re dealing with- but give it enough time and undervalued assets will appreciate. Similarly, overvalued share prices will come down.
Who says the Australian share market is overvalued?
The most compelling arguments I’ve read recently came from Credit Suisse investment strategists Adnan Kucukalic, Damien Boey and Nizar Torlakovic. The team dug deeper than the usual “PE ratios are not out of line with historical averages” which has been, in my view, the most repeated argument throughout the whole year by the bulls.
While the argument in itself is true, the three strategists acknowledge this much, it is nevertheless misleading for the simple fact that resources stocks are, on a PE measure, very cheaply priced. Anyone can fill in the result of this: take away resources and what you see is a picture of PE ratios that are higher than normal.
The beauty about Credit Suisse’s investigation is that the same argument holds true on numerous measurements. Every time you take out the resources stocks a picture of overvaluation emerges.
Here’s what the strategists noted somewhere in the middle of the report: “In trying to diversify from booming, but risky, resources, the market has bid up the prices of defensive assets, in particular, banks and LPT, with both experiencing 30% multiple expansions from their 2003 lows. Interestingly, the last time this happened was in 1999, a year before the NASDAQ collapse.”
Don’t you just love those historical comparisons?
Macquarie recently drew a parallel with 1987. SB Citigroup strategists Adrian Blundell-Wignall, Alison Tarditi and Richard Schellbach added their say on Wednesday morning: “Moral hazard problems associated with private equity and the ready availability of liquidity, both here and globally, are driving up equity prices beyond reasonable returns, primarily in the Industrials. Greed has become a factor and comparisons with elements of the late 1980s come to mind.”
Citigroup issued a strategy report which was very alarming, drawing a comparison to “similarities with the 1986-87 market in relation to exuberance and deal making” and advising investors to “avoid stocks with abnormally high returns where signs of excess are apparent”.
Citigroup has a fair value for the ASX200 index of 4884, but would be willing to accept the 1-standard deviation both ways which gives us a range between 4278 and 5489. Wednesday’s weakness has pulled the index back into the range with the closing level at 5429, but the index remains at the very top of the range nevertheless, and the end of the year is still a few weeks away.
For Industrials Citigroup’s fair value is 7613 (which gives us a range between 6840-8472), and for Resources it is 3972 (range 3351 to 4707).
The ASX300 Resources index last closed at 3,505.4.
Credit Suisse strategists concluded in their own right: unless you’re an investor looking for cheap resources stocks, there’s no need in buying anything at the moment as everything else in Australia is expensive.
This brings us to the obvious question: in a world flush with cash, why is nobody buying resources stocks? After all, parts of these funds are often referred to as the “smart money” which makes the question particularly intriguing.
Maybe the answer is to be found in the copper market. As you may have guessed, the omens for copper are not positive.
Some commentators have recently pointed out the spot price for copper has now weakened to near or even below their forecasts for the year. This is not a positive sign as it may indicate earnings forecasts may need to be cut. Copper has been the biggest earner for both Rio Tinto (RIO) and BHP Billiton (BHP) over the past years.
More importantly, even more than crude oil, copper has grown to become the benchmark of the Commodities Super Cycle.
As highlighted by resources analysts at ABN Amro, since 18 October LME copper stocks have risen day in and day out. Total LME inventory has now risen to 151,300 tonnes, the highest level since April 2004. What makes this development even worse is that from a seasonal perspective inventories should have declined.
ABN Amro believes the metal has only one way to go from here and that is south. (The analysts even suggest they may have to cut their own price forecasts down the route).
It becomes very interesting when technical chartists at Barclays Capital (now we’re talking resources bulls!) seem genuinely worried in their daily market reports. The copper price is now balancing since a few days on the so-called 200 days moving average. If it drops below the average, and does so convincingly, the trend would seem to have reversed and a steep fall could be next.
Given copper’s role as a bellwether for everything commodities this would likely have far reaching consequences.
Barclays Capital chartists don’t think the negative scenario will happen.
Chartists at Citigroup have no such faith. On Friday they thought copper was “staring into the abyss”. They believed copper had landed at a pivotal point comparable to where the Nasdaq was at in November 2000.
If the red metal breaks down from here it is going to be the end of the world as we know it, for a while at least, Citigroup chartists believe.
Of course, the underlying theme behind all this is apparent weaker economic growth in China in combination with expectations of weaker growth in the US.
This week saw GSJB Were join the growing list of experts cutting their US GDP growth forecasts for the coming year. The coming quarters may turn out very weak for US data and some brokers, such as Merrill Lynch, think this will push the Federal Reserve into cutting mode again.
It’s easy to see why resources stocks are trading cheaply as it remains yet to be seen whether they are a genuine bargain.
Till next week!
Your editor,
Rudi Filapek-Vandyck
(as always splendidly supported by the Fab Three Terry, Greg and Chris)