REPEAT Rudi’s View: This Time It’s (Not) Different

This story features MONADELPHOUS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: MND

(This story was originally published on Wednesday, 23rd February, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

 

– it would seem my personal indicator has once again correctly indicated the share market was overheated

– as long as investor sentiment remains positive towards the US economy, any pull backs are likely to remain benign

– valuation may not seem to matter in the short run, it always finds a way to rise to the surface

 

By Rudi Filapek-Vandyck, Editor FNArena

Most investors don't look at the share market in terms of "value". They might have done some homework and concluded there's a positive story behind their investment decisions, but more often than not they ignore whether this story has now already been priced in. Price to Book? Price-Earnings ratios? All too difficult. And besides, who decides these things anyway?

Others take guidance from charts and price patterns from the past. Momentum is the big driver for market participation interest. Admittedly, it's all not made any easier with plenty of cheerleaders on the sidelines who are constantly trying to give investors the feeling they will miss out, unless they join the party…NOW!

If you have been closely observing market and price movements for a while, like I have, you come to realise how accurate Benjamin Graham's description of the share market still is. More than six decades ago Graham declared: in the short term it's a voting machine, in the long run the market is a weighing machine. Benjamin Graham has had a pronounced influence on his best-known student, Warren Buffett. The message Graham wanted to get across is that in the short run there's about a million reasons why shares can move up and down. None of these reasons is likely to have any direct relationship with the intrinsic valuation behind the share price.

In the longer run, so was his personal experience, "value" finds its way to rise to the surface, either positively (undervalued) or negatively (overvalued). It has been said that when young student Warren once asked him the question why that is, Graham responded by shrugging his shoulders. It's just the way it is.

One problem with Graham's analysis is there is not one universal way to determine the "value" of a stake in a company. One of the key factors in all calculations made are forecasts. We all know what that means. Danish physicist Niels Bohr once put it very succinctly: making predictions is very difficult, especially about the future.

At FNArena we offer investors the tool of consensus price targets. It's not a pefect one-size-fits-all, but then what is? Subscribers can do their own research and via the website they can see for themselves which stocks are trading near, or above, consensus price targets. I have called such occurrence the "Icarus Effect". More often than not, rising above consensus target is the harbinger of weakness to come. Sometimes, however, the share price is running ahead of target adjustments yet to come. This is why consensus targets cannot be applied in a software program. It's a tool that requires human assessment and insight.

Note, for example, how pick and shovel service providers such as Monadelphous ((MND)), WorleyParsons ((WOR)) and Fleetwood ((FWD)) have persistently traded above targets since late last year. And today, Wednesday, 22 February, it turned out the upwardly revised consensus target for Monadelphous landed right smack where the share price had been all this time. So whereto now?

The most important application of consensus price targets, however, remains in relationship with share prices for major banks in Australia. Strange but true, this is where consensus price targets as a tool found their origin. Once upon a time, many years ago now, I observed the gap between targets and bank share prices provided a reliable indicator for risk appetite and valuation for the market overall. In other words, when share prices for major banks are trading above targets, investors have become too exuberant and complacent, the market is running hot, and it needs to cool down.

History shows such events are often not just followed by a simple retreat, they often precede market corrections, if not sell-offs.

When you look at the index's price chart for the past years I can confirm that nearly every pull back, and every correction, has been preceded by bank share prices reaching too high. I can even do this from memory: April 2010, January 2010, November 2007,..

Nine days ago, I once again warned the share market was ripe for a pull back. It seems I was correct again. My personal gauge for market overheating is still working splendidly.

My warning at the time (see "Rudi's View: Life Beyond Q2") triggered two types of responses from readers. One was: what do you think about predictions share markets are in for a correction of up to 20%? The other was: while I respect your personal insights and experience, have you considered that this time you might be wrong?

Let's start with the first question. While a correction of 20% is always a possibility, and one should never exclude anything when it involves people and sentiment, I would argue that on the basis of the market's current valuation such a correction seems rather unlikely. Yes, we've all seen the Great Sell Down between late 2007 and early 2009, but one should always keep in mind that at the peak share prices were massively overpriced (still there was no shortage of cheerleaders at the time). To name but one example: shares of BHP Billiton ((BHP)) traded at $50 at the time, when profits were nowhere near what they are today. Yet today's share price is still below the share price back then.

In essence, judging the share market is not different from judging individual share prices. A stock that is trading on 24x forward looking earnings per share, and then runs into bad news has a lot more downside potential than another one that's already trading at a multiple of 7x. While I am of the view that the majority of experts and commentators doesn't genuinely understand the reasons why the Australian share market has been de-rated over the past twelve months (I intend to come back to this another time), I wouldn't go as far as to describe the current market as "significantly overpriced". Certainly not after the pull back we've seen over the past sessions.

Take it from me, the market is not as cheap as many an expert wants us to believe it is.

No doubt, some commentators elsewhere will argue none of the above applies. It's all due to unforeseen developments in North Africa and the Middle East and no-one could have predicted them. Such reasoning completely misses the point. When risk appetite runs too high and complacency rules, something will happen to put a break on the runaway herd. While it is difficult to pinpoint precisely what exactly will drive the reversal in sentiment, history shows time and time again it will happen.

It's just that putting an exact timing to the reversal requires the prescience of a clairvoyant. I do not have such powers.

What I do have, however, is the experience of observing share markets both in Europe and here in Australia since 1995. I was there in the run-up to early 2000. I was here in the run-up to November 2007. It's funny, but the longer the experience of doing this, the more often that same question is being asked: what if this time is different?

I agree. Every time is a bit different. But what doesn't change is that "value" will still end up being the ultimate determinator of whether an investment will generate a good return, or not. This is why my personal indicator -bank share prices against targets- is such a powerful tool. Even if tomorrow the world goes really crazy, and we do a 1999 or a 2007 all over again, I will still be pointing out that bank share prices are too expensive when they rise above consensus price targets. And unless these share prices precede a re-rating, like in the cases of Monadelphous et al, I will sleep like a baby at night, knowing that, allowing time to do its work, true valuation will come to rise above the noise.

Just like you, I know all about economic data in the US, and corporate profits and money flowing back in, and the fear of missing out. The experience between 2004-2007, followed by the period between March 2009 till today, has shown me valuation limits do jump to the fore when all is getting pricey but still running. After all, this is why my warnings in 2010 (April and January) and in late 2007 turned out correct. This is why you should all pay attention to my indicator. And next time it happens again, don't ask whether this time is different, ask whether banks deserve to be re-rated even when regulatory limits are still hanging over the sector and while funding keeps downward pressure on margins and overall demand for credit remains benign.

Late last year, I asked for some feedback and we received plenty. I will return to that subject another time too. One of our long-loyal subscribers, Jacqueline, used the opportunity to send me a message about how she has used every one of my warnings to sell all her shares and buy back into the share market at cheaper prices. While I would not advocate such a strategy for everyone to follow (investing is longer term remember), I do believe that paying attention to when markets become overheated is but a prudent thing to do. Even if this means you might miss out on that last bit of the rally.

Having said all of the above, I also believe that as long as investor sentiment remains positive towards the economic recovery in the US, all pull backs are likely to remain relatively shallow. Right now I have observed share prices for banks in Australia have retreated much quicker and much further than the market overall. Building upon everything I wrote above, this would suggest this pull back is creating a platform for the share market to rise above the levels seen earlier this month. ANZ Bank ((ANZ)) shares, for example, are now some 8.5% below consensus target.

In conclusion: it's never genuinely different, really. Valuation counts and it pays to pay attention to my personal indicator. It's not that difficult to know when a market is bubbling higher. It's when bad news is ignored and everything else is put in a favourable light. Disappointing data in the US? Must have been the weather! Revolution in Tunisia and in Egypt? These countries only represent a tiny part of global GDP! Tightening in China? It hasn't impacted so far! Refinancing problems for Portugal and Belgium? We've become tired of that same old tune!

If you line up all the items that were casually ignored by US equities in the first two months of the year, it's not that difficult to see when a market is turning into a bubble. My personal indicator merely provides the extra-affirmation.

 

(Note a paying subscription to FNArena comes with an e-booklet "Five Observations (That Matter)". Banks and consensus price targets are two prominent subjects in this booklet. Paying subscribers who have not yet received their copy can send an email to info@fnarena.com)

 

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

 

Click to view our Glossary of Financial Terms