REPEAT Rudi’s View: April The Promise?

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FNArena editor Rudi Filapek-Vandyck shares his insights and analyses on a regular basis with paying subscribers via stories labeled 'Rudi's View'. On occasion, one of these stories is shared with non-paying members and with readers elsewhere. This is one such occasion. The story below was originally written and published on Wednesday, March 31, 2010.

By Rudi Filapek-Vandyck, Editor FNArena

Anecdotal evidence suggests there are quite a few investors who have been taking some equity exposure off the table as the end of March approached. This includes professional advisors and their clients.

At first consideration, this seems to make a lot of sense. Ever since the global share market rally got on solid footing from June-August last year the usual pattern implies that strength will be replaced by weakness every time we move into a new calendar month. And then, as we move into the second and the third week of the month, strength returns and pushes the share market to a higher level.

This time around there is widespread speculation that portfolio adjustments by large institutional investors have been responsible for most of the direction of equities, currencies, bonds and commodities during the final days of March.

This period also happens to coincide with the closing of the first quarter and thus everything simply had to move into the “right” direction, or so the rumour mill goes, to allow the big players in the industry to advertise with another stellar performance for their funds under management.

If we assume this is correct, then some of the movements we have witnessed during the final days of March should reverse soon as we progress through April. The most obvious one would be a reversal in the EUR/USD trend, which should translate into weakness for commodities and for equities.

This will be even more so the case if yields on US Treasuries start rising again (bonds selling off).

Of course, if we assume that April will simply continue the pattern as described above, then those advisors and their clientele I was referring to in my opening paragraph will be rewarded for their strategy. Supporting their confidence will be the fact that history shows April is usually one of the better months for equities and commodities in the year.

Offsetting this, however, is the fact that March is usually not that good, albeit still positive. March 2010 has been exceptionally good by everyone's standards. This poses the obvious dilemma for investors: has March pulled forward some of April's upside?

So far, nothing of the story behind equities' rise in February and March has changed. One of the emails that is currently going around inboxes at various stockbrokerages throughout Australia contains a chart compiled by someone at Bell Potter, illustrating that economic data releases throughout Q1 this year have mostly surprised to the upside.

This chart is simply another way of showing what I have been highlighting over the past weeks: both corporate results and macro-economic releases have forced economists and analysts to upgrade their expectations. This automatically provided a valuation boost to equities because of the simple fact that higher earnings expectations make stocks cheaper, and thus more attractive.

This process is still ongoing. On Wednesday, just before the start of the second quarter, both Deutsche Bank and BA-Merrill Lynch issued big upgrades to commodities prices and thus for earnings, valuations and targets for related companies.

Add an unexpected take-over offer for Macarthur Coal ((MCC)) on the same day and it is clear overall dynamics for equities, materials stocks in particular, remain positive.

However, that is only one side of the story. Another rather popular email that is currently doing the rounds is one that reflects back on the last time producers of iron ore and coal (bulk commodities) enjoyed such large price rises as this year.

That was back in 2008, and similar to what has been happening this year share prices had been in strong demand prior to the outcomes of the annual negotiations. But it went all downhill afterwards.

To refresh everyone's memory: in anticipation of what was at that time a record jump in annual prices BHP Billiton ((BHP)) shares touched $50, then retreated to rise again to $46 on the official confirmation of a negotiated 80% price rise for iron ore. Six weeks later the shares were at $36.

I am sure nobody needs me to come up with some key differences between now and then -global expectations are on the rise this time, to name but one- but there is a key message behind this email which should not be ignored: offshore investors are questioning whether BHP and the likes are once again at risk of being valued at peak cycle earnings.

To feed their suspicion further, price targets in the market are again trending towards $50, which is the highest level BHP shares have traded at over the past three years (they did so on two occasions). So unless we are about to see further material upgrades to economic growth projections and demand forecasts for base materials and energy, I don't think we will see BHP shares close the gap with these $50 targets anytime soon.

These problems will be solved, of course, if and when we do see some price weakness first.

At first thought, this would only temporarily solve the problem, but, and as pointed out by Deutsche Bank analysts in their sector update, historical trends suggest prices for commodities are more likely to take a step back in quarters two and three.

Such scenario is backed up by analysis of BHP's annual share price patterns throughout the present decade. Investors who don't feel like repeating the data analysis themselves: the best times to buy BHP shares tend to be in Q3 and the best times to sell tend to be towards the end of Q1 as BHP shares traditionally book their biggest gains each year between October and March.

I think the odds are in favour this will once again prove to be the case this time around. The facts speak for themselves. In early October last year BHP shares traded at $36. They closed today at $43.59 (but have traded higher this month). The difference is 21%. Even if BHP shares would manage to fill the gap with the $50 targets between now and late September, this would still only represent further upside of less than 15%.

But let's, for now, concentrate on April. Because apparent share price valuations remain largely dependent on what will happen between now and next year, in other words: it's not so much FY10 that matters (as that has been priced in many times over), but FY11.

To illustrate this with a BHP example: no matter what happens to this year's earnings forecasts, the shares remain expensively priced. But they look very good value on FY11 estimates.

What goes for BHP, goes for the majority of the share market, including the banks.

Under such circumstances share markets take the character of a glass filled to the max with liquid. Everyone carrying it through the room has to walk very carefully to avoid any spillage. And of course, as per usual, there are plenty of dangers around that can cause spillage.

On April 15, the US Treasury Department is scheduled to release its findings into whether China should be branded a currency manipulator, or not.

Last week, former Fed Governor Alan Greenspan branded rising yields on US Treasuries “the canary in the coalmine”. His timing was near perfect as yields have been rising, and they have attracted the interest of worried investors the world around.

Both events took place against a background of disappointing bond issues, both in the US and elsewhere. To make matters worse, history is usually not kind for US Treasuries in April. 10-year yields have risen in each of the past four April months, and in six out of the past seven.

This year, investors in equities will have to bank on a below average increase as the average rise over these past April months has been 25 basis points. On top of recent yield rises, a repeat of the historical average could well spook investors worldwide.

There is also the expected come-back of the US dollar. Much of the rallies in the final week of March have been fuelled by a sudden come-back for the euro. What if US dollar strength reasserts itself? (Investors better not lose out of sight that Greece has to roll over some EUR15bn in government bonds through to the end of May).

The most important danger for the outlook of risk assets, however, stems from disappointing economic data. The leg up since mid-February has received firm support from positively surprising data. How long will this last? And if it does, how long before this starts impacting on interest rate expectations?

If we take a positive approach though, it might just be that April simply brings investors more of the same ingredients that have accompanied the global rally since March last year: a wall of worry, with too many unbelievers on the sidelines, and few daredevils that continue pushing share indices to higher levels.

At least history also shows equities tend to perform best between November and May, so it may well be that all of the worries above are a bit too early on investors' minds.

To paraphrase US author Hall Borland: Will April turn out the promise, that May is bound to keep? Or is April finally ready to live up to T.S. Elliot's description this year: the cruelest month, breeding lilacs out of the dead land, mixing memory and desire, stirring dull roots with spring rain?

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

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