Missing In Action: The Continuous Downward Trend

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This story was first published on Tuesday in the form of an email sent to paying members.

By Rudi Filapek-Vandyck, Editor FNArena

No wonder most market commentators never saw last week's persistent sell-offs coming, all the important action took place in the rear view mirror!

It's a bit of a cheeky observation, I know. But it is true nevertheless. Last week's backward revisions by the US Bureau of Economic Analysis, shortcut BEA, have thrown a completely different perspective on the old saying “lies, damn lies and statistics”, as well as the ongoing expert mantra that China data should always be treated with a grain of salt.

If there's any conclusion to be drawn it is that official statistics are probably not the best tool to accurately gauge what's going on in the world, no matter where they originate from.

Few commentators only have thus far zoomed in on this matter and most who did did so with an ultra-bearish undertone. However, I am actually of the view that the US Bureau of Economic Analysis has accelerated the market's process of digesting the global economic slow down. This is a positive and I am not surprised at all to observe that the sellers decided to stay at home this week, leaving global equity markets to the value seekers, the bulls and the buyers (albeit on ultra-low volume).

First, let's have a visual representation of what has in essence happened in the second week of August. The chart below (courtesy of CLSA) shows the difference between consumer consumption levels according to the originally reported, unrevised data and last week's unexpectedly revised data. Note the revisions go back as far as late 2006 (!).

Apart from the logical observation that the gap between the two is rather large, and has only widened throughout 2009 and in more recent times, note how the original data indicated US consumer spending had already exceeded the levels of late 2007-early 2008 and was at a new high. The revised data, however, indicate US consumer spending is still nowhere near previous peak levels.

Compare this to being talked into a cycling holiday by your parents, telling you the distance to get there is only twenty kilometers. However, after a few hours pushing the pedals you find out they lied to you. It's not twenty kilometers, it's fourty. The good news is, however, you've already done thirty.

A similar process has taken place around global markets in the week past. The first response was one of shock and horror; OMG, the bears were right, the recovery in the US never was even close to what the data and the more optimistic forecasters had assumed! (Thus: Sell! Sell! Sell!)

However, on second assessment, there are lots of positives to draw from this, not the least the fact that the barrier for future improvement has been placed significantly lower. And so it is that a shock announcement by BEA is likely to have created a bridge towards less bad news in the year forward – all else being equal.

If you think all of this is a bit too far off the main road, then consider the following observation made by economist Avery Shenfeld at CIBC Markets, one of few who genuinely zoomed in on this matter on Friday:

“The result is that we’re no longer looking at a material second-half slowing, because as it turns out, the economy has already slowed.”

To put this in another way: what BEA has effectively done is killed off the negative trend that was starting to appear on most investors radar screens and which, expressed in GDP growth terms, looked like 5%, then 3.7%, then 2.4%, with the next revision likely to bring the latter down to 1% or even lower.

Obviously, with “the trend is your friend (until it bends)” as one of the most used sayings in financial markets, the risk seemed that ongoing negative data and revisions would continue dominating financial markets for weeks to come (if not longer).

What BEA has done is lower the barrier so much that the risks are now skewed to the US economy hitting a new plateau this quarter or next, from which gradual improvements can be much easier generated. For a market that was increasingly trying to look past further short term weakness, last week's move would represent not just a Golden Gift, but one at the Perfect Timing as well.

Mind you, most market observers and commentators have remained completely oblivious to all of this. The bears are still expecting equity markets are on their way to re-testing the June lows, or worse, while the bulls never gave up their mantra that things were getting better, despite every data release seemingly indicating the opposite.

Of course, the significant data revisions by BEA last week won't lead to the creation of new jobs in the US, nor will they assist companies in making more sales and profits, but for a market that is so much sentiment driven as this market is and has been in 2010, last week's revisions might turn out the key difference between revisiting those June lows and moving higher instead.

Even if it turns out the months ahead will bring us but ongoing deterioration in US jobs and consumer spending, a scenario that still cannot be completely dismissed, then last week's data revisions have at the very least bought extra time for equity markets.

All of this, of course, with the caveat of “all else remaining equal”.

I note several other negative trends might be equally coming to an end, such as the leading indicator from the Economic Cycle Research Institute (ECRI), about which I have written repeatedly in the year past. The bears will tell us the index has now fallen so deeply in the red, this must be a bad omen for what lies ahead.

This may well prove to be the case, but if deeply negative trends now start “bending” this will further support Mr Market's attempts to look beyond the trough.

More good news has come from the Australian reporting season these past two weeks. Those stockbrokers who had forecast 24% or 26% growth in earnings per shares on average for the Australian share market have been forced to reduce towards 20%.

However, I can report that EPS growth for fiscal 2011 on FNArena's calculations has remained stable around 19%. This is more good news as it takes away -at least for the time being- concerns that those forecasts would need to be adjusted by up to half or so.

Assuming current expectations remain unchanged over the next two weeks (100% unlikely) this places the Australian share market on FNArena's calculations on a Price-Earnings (PE) ratio of 13.2, suggesting a return to the market's historical average of 14 only implies a further 6% in gains or so (ASX200 at 4735).

However, with all banks and Australia's two leading diversified resources stocks trading at PE ratios of well below those figures, the market's average PE might not paint an accurate picture. Australia's Big Four banks are currently trading between 7.8% and 17.1% below consensus price targets. The average of those gaps (13.4%) suggests the share market could well rally around 600 points.

Similar gaps for both BHP Billiton ((BHP)) -21%- and Rio Tinto ((RIO)) -28%- suggest the potential upside could even be larger.

However, let's not get too excited and, above all, let's not loose sight of the fact that -as predicted by myself as far back as late 2008- the US, Europe and Japan are staring at years (plural) of low growth while China is still cruising towards 8-9% growth (coming from double digits).

This story was originally written on Tuesday, 17 August, 2010 and published in the form of an email to paying subscribers of FNArena.

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