Five Wisdoms To Deal With The Great Big Bear

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

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

Technical Chartists and market commentators are telling us that what we are experiencing now is a bear market triggered by a serious downturn in the US housing market and unforeseen domino effects across the globe because of fundamentally flawed opaque financial investment products. While that may be the case, it doesn’t mean the end of the world is nigh. Equally, it doesn’t mean the share market has now become an absolute no-go zone for everyone looking to invest.

Here are a few wisdoms that may assist share market investors in dealing with the changed bourse climate.

1. Every bear market creates a platform for the next bull market

This is not some creative spin invented by stockbrokers eager to lure retail investors back into the market. Take a look at how the stock market has moved up over the longer term: every downturn in history has been followed by subsequent upswings that ultimately took markets to higher levels. There’s a simple mathematical way to prove this. At times of earnings stress and insecurity -such as right now- overall Price/Earnings ratios (P/Es) fall below historical trend and when things pick up again they rise (as we all become more optimistic).

Let’s put this principle in practice:

ANZ Bank ((ANZ)) shares are currently trading at a FY09 PE multiple of circa 9.7. The major banks are used to having a multiple of up to 15 and at times even higher over the past decade. But let’s not be too greedy in this. Let’s assume that ANZ’s multiple will recover to 13 once the main clouds over the sector have disappeared. This would push ANZ shares up to $30, more than 32% above the $22-something they’re currently trading at.

This simple exercise instantly shows you how much “potential” ANZ shares currently carry, even without including the 6.8% in estimated dividend yield. However, the above example only shows why the shares are currently labeled “undervalued” or “cheap”, it doesn’t tell us when the time has arrived for ANZ shares to return to a more normalised PE multiple.

Think logically and you’d probably agree that before we can see ANZ shares back at $30 (they peaked at $31.74 in October last year) the market will need more clarity about what’s happening with financial institutions on a global scale and more insight into how the economic downturn will affect the bottom line and balance sheets of Australian financial institutions.

Long term investors are having a field day at these unusually low valuations, but it all depends on what your horizon is. ANZ is very unlikely to go bankrupt, so the “potential” is very much locked in. But only if you’re in the game for longer than short or medium term. Think three years at least and you’re likely going to look back with fond memories about the day you decided to step in. But anything shorter than that and you might get disappointed. (You might, we don’t know whether this will be the case or not).

2. Value is of little value

This is as good as any other time to start practising the power of the word. Every morning, before you get out of bed, say three times: “Value is of little value”. This is to be repeated at least two more times before the end of the day. This should help you cope better with stockbrokers, market commentators, financial planners and other experts who will be telling you, over and over again, that Australian shares, and especially banks, insurers, property trusts and builders, are currently cheap as chips.

They are, but as stated in Wisdom Number One, this tells you nothing about the timing of their recovery. What you want to be looking at for the short and medium term is “Security”, “Growth” and “Momentum”; probably best to have all combined into one.

In August last year consensus expectations were for the banks to grow their profits by 12% this year. Current concerns are that profit growth for the sector might turn out negligible for the year. This is a big change and explains why banking stocks’ PE multiples have fallen so dramatically. What about FY09? We don’t know yet, but concerns are mounting. Overall, the trend in earnings forecasts for the broader market is still negative.

The only exception, as a group, are resources. But investors better be careful, because this does not apply to all resources stocks. As traditional safe haven sectors such as banks, property trusts and utilities are currently jinxed because of negative sentiment and negative news flow, the market is currently trading without any defensive sectors. This means increased volatility, across the board.

And because resources stocks are currently being promoted as “the new defensives”, they will logically make up a bigger part of investors’ porfolios in the year ahead. It won’t make the overall market less volatile, however, it’ll probably do the opposite. (It still beats me how anyone can promote any stock that swings between $33 and $36 within the same week as “defensive”, but I will not argue with the fact that resources stocks are the place to be).

Resources currently stand out because annual contract settlements seem to be generating higher prices than penciled in by securities analysts while spot prices for the likes of copper, aluminium and oil have surprised to the upside in the first two months of the year. What this means is that earnings forecasts throughout the sector are trending up (opposite the overall trend). In addition, precious metals are still forecast to move higher. Oil and gas forecasts are constantly subject to revisions, but they too have surprised to the upside thus far.

A special note has to be made for oil and gas companies (also proving how little “defensive” the new defensives are). The February results season has revealed that, despite crude oil up some 67% over the past year, most companies in the sector did not report any growth in profits. Some, like Caltex ((CTX)), even issued a profit warning for the year ahead. The key to the outlook for these companies is keeping costs down while actually achieving the planned production growth. A stronger Aussie dollar is too often ignored as well by analysts and investors.

In general, look for companies who did well during the reporting season. They enjoy the positive momentum. And the market is obviously trusting them in continuing to do well. Jump on beaten down stocks at your own peril. As again proven this week by the likes of Allco Finance ((AFG)) and ABC Learning Centres ((ABS)) there’s no natural limit to the amount of negative news possible and, equally, what has become cheaper today can always become even cheaper tomorrow. Another wisdom to keep in mind is: negative news begets more negative news. Investors ignore this at the risk of losing substantial amounts of money.

3. Watch your attitude, dude!

If you want to make a living as a trader, here’s one very important rule I learned from people who’ve spend many decades trading in the markets: keep the trend as your friend, always.

What this means, in effect, is that during a bull market you are likely to make easier (and more) profits by punting on the fact that share prices will go up. However, as we’re no longer in a bull market you should adjust your attitude. Immediately. This means you are likely to be better off by going short (speculating on stocks to fall) or, if your mindset doesn’t allow for such a reverse focus, to stick to a short term trading horizon. In other words: you’re either in the market short or for a short time only. Probably better to be both at the same time.

However, this necessary change of attitude is not confined to traders only, it goes for all types of investors with all types of experience, goals and time horizons. During bull markets positive factors tend to grow on their own and become a craze. Think about how everyone jumped on uranium. And then they all went into iron ore stocks. And then into coal. In between we had nickel and then lead. Under negative circumstances, it’s the negative things that are are magnified. All of a sudden nobody wants to have any part of any property trust anymore. And every retailer will soon find less customers with less to spend on his doorstep. And every company that delivers the slightest disappointment gets hammered.

It is at times like this that investors experience the true meaning of “risk”. Don’t try to be a hero. The odds are stacked against you. A recent study by Credit Suisse found companies that disappointed during results season in a negative market tend to underperform by 100% or even more, and this underperformance was likely to last for many months, in some cases for many years. As I said above: negative things are magnified.

In a bull market there’s always the chance for a takeover to save the occasional dud. In a negative market like the one we’re experiencing right now there’s no such “deus ex machina” (help from out of nowhere) – to put it in simple words: this market will show no mercy and if your only hope is for a take-over to save your investment, you’re in true dire straits. Remember what happened to (the company formerly known as) RAMS ((RHG))? Macquarie Group ((MQG)) reportedly offered to take over debt and major assets of Allco and put a value of $1 on the remainder of the company (that’s right: one dollar!).

If value is of little value during negative times, risk will show its full weight in fool’s gold. The share market has become a more uncertain, volatile and risky place – all at once. We already concluded there are no real safe places left. You should think twice and extra care of what you are doing.

Again, there’s a simple mathematical explanation why negative factors matter more at times like these: if a certain stock falls 20%, let’s say from $1 to 80c, it will have to rise by 25% to return where it was (back at $1). Imagine what this means for shareholders who still own shares of Allco, MFS ((MFS)) , RHG or ABC Learnings Centres…

The overall decline of PE ratios plays a big role as well. In December, Commonwealth Bank ((CBA)) shares peaked at $62.16. The average price target was around $60 at the time. CommBank shares are now trading at $45. The average price target has fallen to $51. What if you bought the shares at $58? That’s what I am talking about: change your attitude. Simply order a few drinks and get over it. Ask yourself whether remaining a shareholder of CommBank is the best way forward to re-gain your losses.

4. Better to ignore the noise

There’s always a lot of noise in and around financial markets, and I am not necessarily talking about rumours that turn out completely hot air.

Last week I read somewhere that Woodside Petroleum ((WPL)) was the only blue chip that was trading higher than at the start of the year. Compared with the share market peak in early November, you’d be hard pressed to find many stocks that are still sitting on a gain.

However, take a look from early February onwards and you’ll see that BHP Billiton ((BHP)) shares went from $36 to near $40. Alumina Ltd ((AWC)) shares went from $5 to beyond $6. Shares of Energy Resources of Australia ((ERA)) are now above $22 compared with $18 in late January. With the exception of Alumina, which is pretty much trading at its average price target, most price targets for resources stocks are still 17% and more above today’s price levels (with upside bias). Maybe that’s the real story you should be looking at.

Part of this constant noise relates to the fact that half of the market finds itself repeatedly behind the curve, while being completely ignorant of it. The latest fashion in the finance industry is to use sentences such as “apparently ignoring the fact that the US may soon be in recession, investors continue to push commodity prices to new highs”. (Watch out for this, every major newspaper has a variety on this sentence in its colums on a daily basis now).

Investors better learn how to ignore these false signals, as the use of this sentence merely proves the author has yet to catch up with how things have changed over the past few weeks.

As I wrote last week, sudden changes on the supply side have fundamentally altered the outlook for commodities such as coal, platinum and aluminium, but also for resources in general. I also wrote that if were a hedge fund trader I would have re-positioned myself from being short to turning long the industry. The latest indications are that’s exactly what has happened over the past few weeks. Speculators, hedge funds and large fund managers have jumped on commodities and gone long. Are these people, sometimes referred to as the “smart money” in the markets, ignoring a possible recession in the US? Think again. Why are they called “smart money” instead of “those who ignore the obvious”?

Equally, many a commentator still has to catch up with the fact that what used to work in a bull market may not necessarily still work in this fundamentally changed environment. Much has been made out of the fact that directors of ANZ Bank, including CEO John McFarlane, have been buying extra shares since the recent sell-down. Past analyses have suggested that imitating directors buying shares in their own companies can be a highly profitable trading strategy.

However, the question has to be asked whether this was not merely something that used to work in a bull market environment. My personal observations are that directors and managers often have a poor record in understanding the finer elements of the financial market, but also in anticipating key points of reversal. At least one director of RAMS bought extra shares after the successful IPO was met by a gradually weaker share price on the market last year. Several directors of high tech company Arasor International ((ARR)) bought shares last year to stop the share price rot. The shares have now sunk below $1 from the $3-something they once used to trade at. And what about management at Paladin ((PDN)) who decided to buy in extra product near uranium’s spot price peak of $136/138/lb last year?

Maybe, given the switch in the overall environment, investors should no longer be looking at who’s buying into his own company, but at which directors and major shareholders are selling some of their stock?

5. Things are seldom that different, really

It always sounds much better to talk of things like they never happened before and surely this must be the worst crisis ever and the worst derailment of global financial markets in the history of mankind. It’ll probably turn out it’s not. And things won’t be that different from what we’ve seen before either. PEs for banking stocks may be at a 17 year low, but they were still lower during the eighties and in the early nineties when another financial crisis hit global markets (and Westpac almost went bankrupt).

As a matter of fact, while one would be inclined to think that a bear market is simply a bull market turned upside down, and from my previous wisdoms you could possibly draw the conclusion that everything works the other way around now than it used to be, but even that is not true.

If you really take the time to analyse what’s happening, and put it in the right context, you’ll see that despite all the confusion, the fears, the sell-downs and the noise, things have in essence not changed that much from how they were before the start of this year.

Banking stocks have been underperforming the broader market since early 2006. Prices for commodities have continuously surprised to the upside. And every year economists and analysts predicted they’d peaked. What were the best performing stocks in 2007? I think they were almost all resources related. What happened to companies that disappointed last year? Most of them underperformed the broader market.

The main difference between now and then is that underperformance now equals a total negative return. As I said before, negative things are magnified, but the stronger stocks will still do better than the weaker ones. Risks have become real, but the basic principles of good investing are still the same: it all comes back to earnings and to how companies manage to secure and grow them. The more earnings they grow, the more appreciation they receive. The same principle applies for how secure the market feels about this growth.

Life on the stock market has become tougher, but you still have to play the winners and let go of the losers. It’s just that punishments for not obeying the rule come quicker and much harder. And as always, there’s no such thing as a watertight guarantee.

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