REPEAT Rudi’s View: The Labor Day Indicator

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By Rudi Filapek-Vandyck, Editor FNArena

(This story was first published on Wednesday, 1st September, 2010. It has now been made available to non-paying members at FNArena and members elsewhere. It follows on from “Have We Forgotten How To Invest?”, Weekly Insights, first published in the form of an email to FNArena subscribers on Monday, 30th August, 2010.)

A few positive developments took place this week. One concerns the release of two slightly improved purchasing managers indices for the Chinese manufacturing industry. While one could argue both releases were merely in line with market expectations, the importance of the coordinated up-tick in both the official survey and its private peer has been perfectly illustrated by the economics team at ANZ Bank:

As anyone can see from the red coloured lines on the chart, history shows Chinese manufacturing has a long standing tradition of retreating in the second quarter, but on every occasion since 2005 the third quarter has subsequently brought a rather sharp rebound.

This, of course, is what had Mr Market excited on Wednesday. With both PMI surveys rising compared to last month, expectations are that further improvements in the months ahead can finally facilitate that rally on share markets many a stockbroker has been waiting for.

The following chart, thanks to Desjardins Securities in Canada, suggests the same seasonal pattern that seems to be behind PMI surveys in China, is also supportive of a rally in resources stocks between now and year-end.

I yet have to complete my analysis of the Australian share market post the August results season, but a few things are undoubtedly clear already: Australian companies are now expected to grow earnings per share in the ten months ahead (plus the two last ones) by some 19%, but most industrial companies sit well below this number.

It's all about resources, resources, resources with the likes of Fortescue ((FMG)), Rio Tinto ((RIO)) and BHP Billiton ((BHP)) expected to grow well above that average growth forecast. Add the fact that these companies are also trading at large discounts to their consensus price targets and it should be clear why the biggest returns -in case of a sustained share market rally- are not to be found amongst industrial companies in Australia.

But then again, the dour sentiment that characterised the August past was not so much because of China, or because of commodity prices, it was all about the sluggish US economy. Mind you, many an economist has not given up yet on the prediction that data in Europe will be the next ones to show a downward trend.

Let's stick to the US, for now. The Consumer Metrics Institute, which I have mentioned a few times over the weeks past, updated its registrations of discretionary purchases over the internet by English speaking American citizens – and it aint a pretty picture:

Here's the conclusion drawn by the Institute last week:

“Barring some sudden reversal in consumer attitudes and habits, the 2010 economic slowdown will be longer and at least as painful as the one experienced in 2008. Furthermore, the shape of this contraction event indicates that it is probably not an independent "double dip", but simply a continuation of the "Great Recession" of 2008 after a few quarters of now lapsed consumer stimulation.”

To put it simply: the Institute is not a believer in a “double dip”, because the US economy is likely still in its original dip from two years ago.

Within this context I happily repeat global equity markets have in essence traded sideways for twelve months now and indices in Australia are still below comparable levels of August and September 2009. The good news is, however, that if this week's buoyancy continues price charts will show the trend of posting lower lows and lower highs might have come to an end – this will be seen as a clear positive by many.

I picked up the following historical observations by James Dines, publisher of The Dines Letter in the US; let's call it the US Labor Day Indicator:

History shows that if the US share market declines in the four-day week following Labor Day investors should stay away from the market for one full month. The odds are then in favour of a pattern that sees a new low being reached in October, after which a recovery/rally kicks in.

Apparently, staying away until October would have been the correct thing to do in 1994, 1998, 1999, 2000, 2001, 2002 and 2008.

However, in case the opposite happens and US equities gain during those four days instead, the odds are in favour of the rally continuing. This happened in 1993, 1995, 1996, 1997, 2003, 2005 and 2009.

There are exceptions to the rule and share markets did not continue their rally after gains during the four days past Labor Day in 2004, 2006 and 2007.

Nothing works always and forever, but this is certainly something (some) US investors will pay attention to.

Labor Day is the coming Monday (6th September) so this makes next week a bit more important than usual.

Apart from all of the above, investment experts in Australia and elsewhere have been focusing on the relative value that has become apparent in equities. The following chart by Stifel Nicolaus at US Global Investors suggests the US stock market had never been as cheap as in 2009 -never!- and US shares are still nearly as cheap as they were at the end of the Great Depression, in 1939.

Another chart, published by the Financial Express, suggests we are at the beginning of a new bull market, or at least of positive returns for equities.

Analysts at JP Morgan took a different approach, but their suggestion points into a similar direction: equities should now move into an extended period of outperformance compared with bonds.

Here's one chart from Perpetual which I included in my story on Monday, but which I think is worth repeating:

Last but not least, analysts at Citi pushed out their anticipated surplus for the global iron ore market this week. Which is important for the following reason: higher prices for longer means more profits for longer for Australian producers.

As an immediate effect, Citi's forecasts for BHP Billiton ((BHP)) now foresee further growth past FY11. Previously, Citi's forecasts assumed a decline in profits from FY12 onwards.

Not everyone is agreeing with Citi's new forecasts as yet, but then again, the more bullish forecasters were anticipating continued growth in earnings per share anyway. Just shows how important those bulk commodity prices have become for the big two diversifieds in Australia.

On the other hand, I also note analysts at BA-Merrill Lynch agree with the warning issued by analysts at RBS in August and that is that profit multiples (otherwise known as the Price-Earnings Ratio) for Wotif.com ((WTF)) are simply too high for what the company can reasonably achieve in terms of earnings per share growth in the years ahead.

I note UBS also downgraded the stock last week. Wotif is a stock highly recommended by many stockbrokers and financial advisors. I can smell another CSL ((CSL)) is in the making.

These and other themes will have my attention in the days and weeks ahead.

P.S. I – In case you are reading this story through a third party channel and you cannot see any of the charts, technical limitations are to blame. Our apologies.

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