REPEAT Rudi’s View: Increased Risks Undermine Momentum

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By Rudi Filapek-Vandyck, Editor FNArena

While reading through daily research reports issued by major stockbrokerages in Australia it has become quite impossible to ignore the fact that earnings expectations are no longer in a clear uptrend in Australia.

I haven't kept a ledger, but my impression is that every report in five, on average, now contains lowered earnings estimates, while an equal equivalent contains higher estimates.

If we take a positive view, this means that downgrades and upgrades are still keeping each other in check, more or less, and that the majority of reports contains no changes, implying most forecasts for this year and next are on balance still looking okay.

Also, most cuts to forecasts in relationship to large caps are relatively minor. We're talking two percent here and three percent there. The best example of this have been the Australian banks. ANZ Bank ((ANZ)), Westpac ((WBC)) and National ((NAB)) all beat market expectations with their interim results, but all three saw earnings estimates drop by a few percentages for this year and next.

For some of the smaller cap stocks, however, earnings revisions have come hard and fast. For example, JP Morgan cut its forecasts for engineer Ausenco ((AAX)) this week by 21% and by 8% for this year and next, while analysts at Citi reduced their already downgraded forecasts for Sigma Pharmaceuticals ((SIP)) by another 10%.

The optimists among you will no doubt argue that none of the above seems enough to stop the local share market from resuming its uptrend once the situation has cleared up in Europe. After all, the market sell-off coming into May has been far, far worse than the loss in earnings growth expectations for the majority of Australian companies.

This is true. However, what has become clear is that equities in Australia have now lost one of their main drivers since March last year: continuous upgrades to forecasts. This automatically makes the upcoming results season in August a very important one.

In the meantime, we will all have to find out whether the pause in April will turn out just to be that, a pause, or whether it marked a reversal in the underlying trend. In case of a reversal, even only on a minor scale, I'd be inclined to think the Australian share market will not be able to cross the 5000 level this year. Or if it miraculously does, it won't be able to hold on.

I base this prediction on the fact that I am a firm believer in the principle that trends are an investor's best friend. If the trend turns down in earnings forecasts, the share market will not be able to sustain full-looking valuations. It is that simple.

It thus can only be of concern that economists have started to reduce their growth projections for China and for Europe. The latter won't be a surprise to anyone, I presume. The first probably requires a bit of explanation.

It probably won't have escaped anyone's attention that together with most equity markets worldwide, industrial commodity prices seem to have peaked in April too. Apart from a retreat in global risk appetite, certain developments in China have been responsible as well.

Chinese policymakers are fully intent in causing a hard landing for their domestic property market which is showing all signs of a liquidity driven bubble. Because they can. It won't bring down the economy overall, but it will teach speculators a lesson. Unfortunately, such a crash is likely to also impact on demand for building-related commodities.

It is this realisation in mid-April that has made investors increasingly gun shy when it comes to buying more exposure to copper, nickel and iron ore, for example. Especially since prices were already at elevated levels. Prices have pulled back since.

Again, this seems but a very good reason to not push share prices of producers of these commodities to the max. Share prices of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) may well look ridiculously cheap on current forecasts for fiscal 2011, but it is a telling sign that both have only bounced back from the recent carnage in a rather measured manner.

Technical analysts will add that recent carnage has pushed both share prices below the 200 day moving average – not a positive sign.

Observe also the Australian dollar has been unable to surge back above US$0.90 – another sign that global investors have become more cautious towards the China-commodities story. (The overall mood is not supported by newswire headlines swirling across the internet that the Chinese share market has this week “officially” retreated back in bear market territory).

Bottom line: none of the above proves that the underlying trend in earnings forecasts is about to turn into a barrier instead of providing support, but risks are on the increase and thus extra caution seems but warranted.

This particularly applies to Australia, where increased taxes for resources and higher interest rates form part of the outlook, while economic data seem to be softening.

Some unexpected surprises might come from fundamental changes taking place on currency markets, with the euro now destined for much, much lower levels against most other currencies; at least that's what it looks like in the aftermath of the PIIGs problems in Europe.

Investors might want to take note that if the euro is now in a multi-year downtrend, and certainly half the world seems to believe that is the case, than one of the victims on the Australian share market is likely to be bloodplasma and flu vaccine producer CSL ((CSL)).

So far, most of the FX attention in regards to CSL has been on how a strong AUD/USD is eroding the company's earnings for Australian shareholders, but analysts at Morgan Stanley reported this week CSL's bottom line is even more vulnerable to changes in values for the euro and the Swiss franc.

While this implies that current market expectations for this year (FY10) will have to be adjusted downwards to the tune of some $35m (roughly 3.5%), the real impact would be on FY11 numbers. Morgan Stanley suggests that, even on relatively healthy underlying growth figures, CSL's earnings per share in FY11 could potentially fall below this year's projected EPS figure.

If correct, this implies some 15% downside to current consensus expectations. Obviously. It would also imply that CSL shares will not be able to close the gap with broker target prices over the next twelve months. If anything, this likely means those targets will be pulled back.

Based on FNArena's consensus calculations, CSL shares are currently trading on Price-Earnings ratios of 17.4 and 16.2 for FY10 and FY11 respectively. Current consensus forecasts are for growth in earnings per share of 10.9% and 7.3% respectively. The average price target is $38.13, some 15% above where the share price is right now.

All those numbers now seem under threat because of a new trend for the euro. Another earnings headwind for the Australian share market?

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