Rudi On Thursday

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(This story was initially published on Wednesday, December 2. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

Economists at Goldman Sachs published a framework to assess economic growth and share market performances throughout the various stages of the economic cycle. Understanding their work is understanding the cycle and -possibly- understanding what is happening in financial markets today.

First, let’s go back one step, and concentrate on what’s happening in commodity markets.

Once upon a time the size and trend in global inventories would provide investors with a fairly good indication where prices for commodities, base metals in particular, were heading to. That script was thrown out of the window this year. I have included two charts from a Calyon presentation that show the build up in inventories for aluminium and nickel since mid-last year. As clearly shown on these charts, prices for both metals moved higher from early 2009 onwards, while inventories simply kept rising.

(If you cannot see the charts I apologise. It means you are reading this story via a third party channel with technological limitations to blame).

I could include charts for other base metals, or for crude oil, but they pretty much all look similar, except for copper, which is why anyone would be hard pressed to find a medium-term copper bear with conviction these days. Copper inventories are equally on the rise but they’re still lower than earlier in the year.

It is this de-coupling between commodities and their traditional link with registered inventories that fuels widespread doubts whether current prices are anything other than a liquidity (or: speculator) driven bubble that might prove unsustainable in the twelve to eighteen months ahead. Add the growing realisation that “apparent Chinese demand” means actual demand plus stocking of massive inventories in the country and it is not difficult to see why some marketwatchers feel commodity markets are treading water.

Strictly taken, prices for the likes of copper, oil and nickel should be heading lower. Not only is such the usual seasonal pattern, but Chinese inventories are now believed to be filled and actual demand in the country is traditionally weak this time around. Recent import data from China have indicated as much.

Yet the majority of investors and market commentators appears convinced we will see higher prices, and higher share prices, before moving into 2010. How to explain this dichotomy?

One word: hope.

Prices for commodities continue to track global risk appetite, and global risk appetite is now built on the premise that global economies, including those in the US and Europe, will gradually recover from their trough in the quarters ahead. Many an economist will tell you: this seems but a reasonable assumption to make. After all, economic data and indicators continue showing improvement from Beijing to New York and from Tokyo to Berlin.

Don’t forget also: economies are cycling relatively weak points of reference. It’ll only get tougher as we move further into 2010.

The overall expectation is thus that apparent market demand for commodities will drop between now and February next year. From then onwards expectations start diverging. Chinese imports should pick up again, though likely not with the same strength as we’ve seen this year (would that be possible?) But demand in Europe and the US should pick up too because of the re-stocking cycle.

This is why current views about the outlook for 2010 are so diverse. If Chinese demand proves strong and Europe and the US jump on board this could give commodity prices a big boost next year. This is what makes some market experts quite excited about what might happen in the year ahead. (I already received emails with questions what I thought about predictions that crude oil prices might be back at US$147/bbl in a year from now).

There are, however, plenty of other scenarios possible. Many of these should still turn out a net positive for commodity prices next year -such as weaker Chinese demand compensated by re-stocking elsewhere- but some won’t be positive at all.

In essence, the story for commodities in 2010 looks pretty similar as for equities in general. Both are being supported by investor hope that economies are now on the road to sustainable recovery. If correct, this means stocks priced on elevated FY10 multiples are not expensive and FY11 valuations will become “de rigeur” (I happily refer everyone to the R-Factor on the FNArena website).

Similarly, prices for copper and crude oil and nickel won’t turn out expensive at current heights, and they all should be higher by the end of next year.

This is also why investing in the share market, and in commodities, at this point in the cycle continues to require a leap of faith. As shown last week when a tiny Muslim state on the big Arab peninsula asked for a temporary moratorium on billions in debt, investor confidence in positive scenarios next year remains low, vulnerable and fragile. Back in the previous bear market of 2000-2003 all it took was one relapse in one quarterly US GDP release and risk appetite instantly took a significant step back.

There are no guarantees the present recovery will develop smoothly and without encountering any barriers.

According to research conducted by economists at Goldman Sachs we are now in the transformation phase when “hope” will start materialising through increased earnings and returns for companies worldwide. This should confirm that asset prices have not run up too high thus far.

Let’s take a closer look into the framework devised by these economists, who are based in Europe and whose work is based on historical analysis of economic cycli since 1970. Specifically they zoomed in on earnings momentum and share market multiples throughout the various stages.

The worst stage of the cycle is the one we experienced from late 2007 onwards: the economy is weakening and equity markets fall into despair in response. This is the worst stage, when both earnings and multiples take a dive, and share prices follow suit.

Then comes “Hope” – the stage we’ve experienced since March this year. This is when share prices move up because multiples rise (on hope) but earnings have yet to follow. Ironically, this is, from an investment return point of view, the best stage in the cycle. Uncertainty is highest, but so are the returns that can be achieved.

After “Hope” comes the actual “Growth” stage when economies do post positive numbers and companies can finally start releasing growing profits. This is the stage we should be moving into right now. Mind you, this is the second least profitable stage of the cycle as far as share market returns are concerned, because now company earnings have to play catch up with expectations. Multiples no longer expand in spectacular fashion.

After the Growth stage comes “Optimism”, which other people would refer to as “Exuberance”. I think we all know very well what that stage looks like. It’s the second most profitable stage in the cycle. Of course, after that we go back to the beginning and things start all over again.

Goldman Sachs believes the transformation into the next stage will take place in 2010.

Market strategists at GSJB Were in Australia have adopted the work done by Goldman Sachs economists in Europe and put it to work in Australia. Their conclusion: the Australian share market is likely to gain some 24% between now and December next year (ASX200 index at 5700). One year later the index is projected to reach 6100 (implying a return of 33% over two years).

In terms of earnings growth projections, the minus 15% for industrial companies in FY09 should be followed by a mildly positive 5% average gain in earnings per share this year (FY10). After that we should see 17.5% growth in FY11, followed by 10% in FY12.

For resources companies the numbers look a bit different: minus 40% (FY09), minus 10% (FY10), to be followed by a positive 45% growth in FY11.

In terms of duration, stage “Despair” lasts on average 26 months, stage “Hope” 10 months, stage “Growth” 33 months and stage “Optimism” 14 months.

It turns out we left stage one sooner, but what does this tell us about the duration of the second stage?

In stage three, argues Goldman Sachs, commodities will outperform both equities and bonds, and individual stock picking will become key, instead of the all-encompassing sector rotations we witnessed over the past nine months.

Stocks likely to do well are those likely to gain most from the economic upturn: think transport, media (through advertising), employment and inventories (re-stocking), plus building and mining. GSJBW still likes the banks (as does the R-Factor on our website) and has started to look for more exposure to USD leverage. The reasoning is that if the US economy surprises to the upside, the USD will do so too and this will reverse the current one-way relationship between the Australian dollar and the greenback.

Commodity experts at Citi, on the other hand, warned this week that investors are likely to overlook the fact that costs continue rising for mining companies. This would suggest earnings disappointments will follow during the upcoming results season.

With these thoughts I leave you all this week,

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab team at FNArena)

P.S. I – Adopting the Goldman Sachs framework in Australia has led to some changes in GSJBW’s Model Portfolio. The strategists still like Downer EDI ((DOW)) and Boral ((BLD)) but they have now added Amcor ((AMC)) while getting rid of OneSteel ((OST)). Exposures to REITs and consumer staples champion Woolworths ((WOW)) have been reduced. Instead came Computershare ((CPU)) and Macquarie Group ((MQG)).

P.S. II – To stay with the theme: GSJBW also updated its Conviction List this week. No changes were made, but it was noted the list once again outperformed the market in November. Current Conviction Buys are Aquarius Platinum ((AQP)), Bradken ((BKN)), Downer EDI, National Australia Bank ((NAB)), News Corp ((NWS)), Seek ((SEK)), Ten Network ((TEN)) and Wesfarmers ((WES)) while Macquarie Infrastructure ((MIG)) and Paladin Energy ((PDN)) are the only ones on the Conviction Sell list.

P.S. III – All paying members at FNArena are being reminded they can set an email alert for my editorials. Go to Portfolio and Alerts in the Cockpit and tick the box in front of Rudi On Thursday. You will receive an email alert every time a new editorial has been published on the website.

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