What A Lousy Timing, Marius Kloppers!

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By Rudi Filapek-Vandyck, editor FNArena

“We have been saying -not hinting, but saying- we believe the first [US] consumer recession since 1991 is next.”

If you really want to know what has caused most global share markets to retreat over the past week or so, than look no further than the above quote. It is taken from a recent market commentary by Merrill Lynch North American Economist, David A. Rosenberg.

Rosenberg has been on the bearish side of the market since August. What has changed over the past few weeks, however, is that his views have gained wider support and now other highly regarded economists and market analysts share his angst.

It is a fact that has not escaped the wider investment community, both in Australia as in the US. As a result, institutional investors have retreated into more defensive assets and global risk appetite has taken a sharp fall.

One can only guess what the follow-on effect for Australian equities would have been without BHP Billiton’s ((BHP)) attempt to lure the board of Rio Tinto ((RIO)) into the idea of the perfect corporate wedding.

BHP forcing Rio Tinto into play is without any doubt a major event. Some market commentators have already attached the tag “monumental” to it and it is widely believed a general re-pricing of mining stocks will be the result.

Ten months ago, this could have been the event of the century – one that would have triggered faze one of investor mania for everything with a real or perceived relationship to basic materials. Imagine the potential overall euphoria as market forecasts started shifting in favour of ongoing price increases for bulk commodities, as spot prices for uranium kept on climbing at breakneck pace and as most resources specialists were about to draw the conclusion that their copper price forecasts for the year were too conservative. China’s growth figures kept on surprising to the upside as well.

It would have literally changed the world as we know it.

This time around, however, it’s BHP-Rio against the rest of the world – in a more direct manner than most investors in Australia are likely to realise.

Prior to BHP’s confession about its marriage proposal last week, equity markets had rapidly recovered from a sudden global angst in August. As pointed out in my Weekly Analysis last week, from mid October onwards, the market started to struggle and each attempt to push the S&P/ASX200 index beyond 6700 instantly triggered a general retreat on each of the five occasions.

It was my personal favourite indicator -share prices of major banks trading above their twelve month price targets- that alerted me to the fact that the market was running into valuation limits. When I consulted a technical chartist this week, he showed a chart which clearly highlighted the market had been contained by technical resistance, and on Thursday JP Morgan strategists reported the combination of falling earnings estimates and rising share prices had pushed the overall Price/Earnings Ratio for Australian shares to a five year high (index above the 6700).

In the background of all this, the fundamentals for further share price gains have materially deteriorated. Some brokers have dismissed the downward trend in earnings estimates, called it only “minor” or attributed it to a temporarily stronger Aussie dollar, but a closer look into the matter clearly shows otherwise.

For starters, while estimates at some individual stock brokerages have hardly moved since August, this is clearly not the case for the market in general with consensus earnings (EPS) estimates dropping from 12%+ growth to a mere 8% growth for the current fiscal year – this is far from minor.

Secondly, the fall in overall estimates is not solely because of the stronger Aussie dollar -though it is worth pointing out that most valuation models still incorporate an Aussie below its current trading level- equally important have been rising costs. Few sectors only have managed to escape the effect from one, or both, factors. Banks and retailers are among the few, mining stocks are not.

Thirdly, the fall in earnings estimates has occurred on a global scale and is still ongoing. While the bulls in the market have consistently pointed out that the prospects for the global economy continue to look positive, they’ve consistently overlooked the fact that the overall trend is nevertheless down. Sometimes the trend is as least as important as the overall picture.

What has turned several major experts worried is that inhouse leading indicators at some major stock brokerages have now turned negative, signaling economic growth in the first half of calendar 2008 is likely to weaken noticeably. It is for this reason that Wall Street has started to reduce its exposure to technology stocks (they are an overall indicator for global growth). It is for the same reason that Merrill Lynch strategists recently advised their clientele it was probably better to move underweight mining and resources stocks and buy back in the sector in a few months from now.

It is for the same reason that prices for most leading base metals, but copper in particular, have been trending down recently. If one really wanted to be cynical, one would advise the Chinese steel sector to drag out their iron ore negotiations as long as possible – chances are the three main producers will be singing to a lower tune in the first quarter of next year.

Especially since the global credit crunch is far from resolved. Financial institutions still have more negative announcements to make (has anyone noticed: the Europeans haven’t reported anything yet in this second wave) and the US housing sector has yet to hit its absolute bottom (expected in Q1 next year).

Meanwhile, the Federal Reserve says it is officially on hold and inflation is rapidly becoming a worry, partly because of higher oil prices, but also because of creeping up food prices. This will be a problem for emerging economies as well as for developed markets, as witnessed by the Reserve Bank of Australia’s update this week. The world’s second largest economy, Japan, is currently balancing on the edge of a recession while the third largest, Europe, fears the effects from a much stronger euro.

But it is the prospects for the largest economy, the US, which is keeping many an expert awake at night. Richard Berner, co-Head of Global Economics at Morgan Stanley, formulated it as follows this week: “[US] consumers now face their toughest challenge since the recession of 2001, promoting at best sluggish growth for a while”.

And it’s not just the bottom of the pyramid that is worrying Berner: “Two anecdotes suggest that [US] consumer woes are spreading to upper-income shoppers: High-end retailers reported sales declines in October, and a New York auction of a Van Gogh painting failed to attract a single bid”.

His conclusion? “The risk of outright US recession is higher now than at any time in the past six years- And even if the economy skirts overall recession, corporate earnings will likely decline.”

Not everybody has a super strong conviction that the Commodities Super Cycle we have experienced over the past five years will easily last another five. In fact, it is but a fair assumption that on a global scale only a minority of investors believes this will be the case.

It is therefore but a fair assumption that while global uncertainties rule, the expected sustainable re-rating of resources stocks is likely to be delayed – at least until a better outlook prevails.

The way things are shaping up right now investors may even miss out on their annual Christmas rally.

Thanks a lot, (BHP Billiton CEO) Marius Kloppers, for bringing us the event of the century, with a very lousy timing!

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