Trend Spotting – A Commentator’s View

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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

I don’t think we have been properly introduced, so allow me to take the first step. I read research reports, lots of them, every day, six or seven days per week. Hundreds of pages. Some interesting, many boring. I have been doing this for many years now. In fact, I have been able to build a business around my “habit” (if I can call it as such). Now I am surrounded by other journalists who read a lot of research too.

I have no doubt that I read the most research on financial markets in the world. I think that’s kind-a cool. Imagine, a pyramid symbolising six billion people living on this planet. If you rank all those people according to financial research they read and analyse, I come out on top. Yes, that is cool, but nothing more than just that.

We all have something that makes us special. Some of us collect rare stamps, or coins. Someone else might have studied the architectural basics for building pyramids. Some of us can sing (not me). I read research. That’s what I do.

Sometimes, when people ask me what it is that I do exactly I try to make it sound more interesting, I say: I read trends. Wow, that sounds so much sexier than anything I said before. In essence it’s the same thing, but packaged differently. When I read research I focus on changes being made, changes in forecasts and assumptions by all those experts who wrote all those research reports.

At times, when I am really into it, I am able to predict when these experts will start changing their view.

Where my work becomes interesting for people like you, who have an interest in financial markets and in investing, is that I share the conclusions I draw, the observations I make and the insights I accumulate with a database of registered readers and paying subscribers at FNArena, the company I mentioned above (built around my habit).

I would like to say thank you to the Australian Investors Association for inviting me and giving me the opportunity to share a few of my observations with you.

The first thing I’d like to share is something you would expect from someone like me, especially after the introduction I just gave. I firmly believe media and financial experts in Australia do not give enough attention to trends, let alone to changes in trends. Instead, they focus too much on stand-alone facts. I believe trends are under-rated, under-appreciated, under-valued, under-reported – a bit of under-everything, really.

This is a real pity, because, as I said earlier, I find a lot of the answers I am looking for through spotting trends.

At FNArena we monitor the views of ten major equity specialists on individual stocks listed at the Australian Stock Exchange. As such, we offer subscribers the possibility to look up what the views are of these experts on various stocks of interest.

Instinctively, everyone who starts using our tools is drawn towards those stocks that are rated Buy by every expert. While this is understandable, history has taught us at FNArena that stocks with a 100% positive approval rating have about 50% chance to perform well. This is significantly worse than stocks just underneath the top on the ratings ladder.

As such, if I had to make a blind choice between two stocks, and the only information I had was that one stock is rated ten times Buy out of ten, and another one only eight times with two Hold ratings, I’d instinctively pick the second one. Years of experience have taught me seven times out of ten I would end up with the best performer out of the two (this is not an exact calculation but merely an estimate on my part).

Companies that have in the past been rated a maximum total of Buys include BHP Billiton ((BHP)) and CSL ((CSL)). These stocks subsequently performed very well and would have been a good investment at the time. However, companies such as Boom Logistics ((BOL)), Emeco Holdings ((EHL)) and Perseverance Corp ((PSV)) have at one stage equally enjoyed maximum Buy ratings. They all brought their shareholders significant losses instead of investment gains. Perseverance ultimately was heading for corporate failure and was snapped up cheaply by an opportunistic suitor at the eleventh hour.

Companies such as News Corp ((NWS)) and Macquarie Leisure Trust ((MLE)) seem to be always at the top of the market when it comes to positive broker recommendations. It just never seems to do anything to the share price at all.

Interestingly, I noticed that News Corp already started to lose some of its positive support prior to management’s profit warning at the end of October. That should have been the signal for investors the tide was turning.

Ultimately, and this is what I wanted to get across: when I research market sentiment for individual stocks I am not necessarily interested whether a given stock is rated seven or eight times Buy. I look for a potential change in trend. As such, a stock that moves from two Buys to three to four in the space of ten days is poised to outperform another stock that is rated ten times Buy and has been rated as such for the past eleven months. You can take that as a fact.

The same principle can be applied to other aspects of global financial markets. When Chinese GDP growth in the third quarter of this year fell to 9% most media and financial experts would point out this was still by anyone’s account a very good number. True. But they nevertheless completely missed the point. A year earlier Chinese GDP had clocked 11.9%.

Allow me to spell this out: in the space of four quarters, one full calendar year, the Chinese economy had lost about one quarter of its growth speed. One quarter. Twenty five per cent. And it did not happen overnight. This happened through recording less and less growth, quarter after quarter after quarter. Similar to the prior examples I mentioned for individual stocks, I believe the key message about the Chinese economy should not have been “they’re still growing at 9%, that’s still high” – the key message should have been “oh my god, see how fast that decline is taking shape”.

To put it plain and simple: if you look at what has happened in global share markets with share prices of commodity related stocks, and what has happened with prices of publicly traded commodities recently, which message do you think should have attracted everyone’s attention?

Don’t think this is where this story ends either. After four successive quarters of relative sharp declines in economic growth figures I believe the economic decline in China has now become a well-established trend. The Chinese government has announced a gigantic CNY4trn (circa USD586bn) stimulus package to boost its economy, but it will take time before this will have any effect. In the meantime the most logical thing to expect is to see this trend continuing. I wouldn’t be surprised if the current quarter will generate some horrific data for the Chinese economy. One can only hope that the first quarter of next year will start showing some improvement.

Stockbrokers, investors and media commentators are notoriously bad in acknowledging when a trend has turned. The past twelve months have generated at least two outstanding examples of this: banks and resources. According to my observation, some experts have simply never stopped describing the banks as a relative safe haven in turbulent times. Of course, with share prices dropping 50%, and more, eventually these experts will be proven correct.

In essence the same pattern was simply repeated when prices for energy and resources fell off a cliff from August onwards.

If watching BHP Billiton shares weakening from $50 to below $24 represents nothing but “a dip in a longer term uptrend” then I would like to see a definition for “correction”.

According to a famous quote by Warren Buffett, most business leaders lead their company by looking in the rear-view mirror while sitting in the driver’s seat. This is often being extrapolated in that the same applies to investors: more often than not, both conscious and subconscious, investors will instinctively base their view, and their investment decisions, on the basis of one glance in the rear-view mirror.

I know, because I answer dozens of questions from FNArena subscribers each week and many of these questions originate from that same rear-view mirror. Macquarie Group ((MQG)) shares used to trade close to $100. Does that make them cheap below $50? Below $40? Below $30?

Warren Buffett doesn’t spend as much time as I do reading and analysing research reports from stockbrokers. As such he probably would never have thought about this, but according to my personal observation, if anyone has a habit of looking into the rear-view mirror, it’s securities analysts at stockbrokerages.

Here’s a fairly predictable pattern: share price gets sold down, securities analyst steps forward: all this is grossly overdone, nothing has changed really, this stock was already cheap, it is now super-cheap. Buy.

Always dismiss these knee-jerk responses. Every journalist who has been following the share market for long enough knows that as sure as A precedes B in the alphabet, every sell-down in the share market is by definition followed up by at least one analyst who steps forward with the “undeserved, over-sold” response. Ignore these messages.

History shows these analysts more often than not have to change their view at a later stage, probably after another few sets of sell-downs. Or they simply stick to their view and will, ultimately, be proven correct. A colleague of mine at FNArena regularly uses the comparison with a broken clock: twice each day this clock will show you the correct time. I like it. This is exactly what all this is about.

Rear-view mirror.

There are probably a hundred reasons why the system works the way it does, but we have no space and no time to study all the finer detail. At the end of the day, it’s not that important. All an investor needs to keep in mind is that most research reports are based on yesterday’s assumptions. That’s why market consensus forecasts are still printing an average 10% profit growth for ASX-listed companies this year (fiscal year to June 2009).

Every top-down economist will tell you this is virtually impossible. It’s like stating that all retailers will increase market share next year (mind you, in this instance I am actually citing from a true story). Always keep in mind that securities analysts are by default always behind the curve. As such one could be excused for asking the question whether

stockbrokers aren’t part of the problem in bear markets.

Just to avoid all miscommunication on this matter: I am probably more qualified than anyone else in expressing a view about research issued by stockbrokers, tipsheets and other financial institutions in Australia. From my personal experiences I can confirm that some of the research I read is very valuable, and I like to repeat that: very valuable. A lot of it is not.

Last but not least it has become apparent to me that Australia still has to come to terms with the fact that the Reserve Bank nowadays is trying to actively communicate with the rest of the country, media and investors in particular. It is my observation that most of the noise reported in the Australian media could easily be avoided if commentators and journalists would pay closer attention to the messages send out by the RBA. That plus the fact that leading indicators show the way, while lagging indicators don’t.

As such it’s an easy bet that job losses are forthcoming in Australia and the unemployment rate will move up from here. Whether Australia will experience two consecutive quarters of negative growth or not (called a “recession”) is in essence the most useless public discussion of all times. What investors, and home owners, and business operators, and consumers in Australia should focus on is that economic growth is decelerating, and fast. The trend is clearly negative and it has not yet been broken.

What this tells you is that tough times lie ahead. Who really cares if in nine months from today some Prime Minister (or central banker) can proudly announce that a recession has been successfully avoided? As if that would make up for the pain of having lost your job, your business or your investments.

Always try to cut through the noise (and a bear market has plenty of it). Think for yourself. Make sure you feel comfortable with what you do. Make sure you are well-informed.

Above anything, however, and I mean a-ny-thing: never act in haste, always take your time. Patience is a genuine virtue for most things you will endeavour and encounter in life. In a bear market, however, patience is the essential ingredient for every investment portfolio, strategy and execution.

Be patient.

*****

I have been invited by the Australian Investors Association (AIA) to speak at their one-day Seminar “STRATEGY FOR RECOVERY” on Friday, 14th November, in Sydney. The above text will form the basis of my speech.

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