REPEAT Rudi’s View: So This Is The Bottom Then?

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(This story was originally published on 6th July 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

One wouldn't draw this conclusion from daily (non-) movements in the share market, but overall confidence that the global economy and equities markets are making a turn for the better is gradually increasing. At the same time, early indications are tepid and far from universal while trading volumes in equity markets remain on the low side. Of course, it goes without saying that more news about sovereign debt risks in Europe and more debt than expected in China isn't really helpful in this regard.

Market analysts at Citi reported earlier this week the stockbroker's Euphoria/Panic Model had generated a Buy signal last week. Citi's Model is a mathematical application of the century's old "contrarian approach" whereby one assumes that when everybody gets all excited and hyped up, it's probably time to start looking for the exit (top is near) while on the other hand, if everybody is ready to throw in the towel it's probably fair to assume a bottom is in, or near.

History suggests this is how financial markets operate and Citi's own historical analysis certainly suggests the automated market indicator gives accurate Buy and Sell signals. And at the end of June we thus received a Buy signal. Meaning what exactly?

In Citi's own words, it means that over a six months horizon (say by year-end), the odds are now 90% in favour of higher share prices.

Investors should note these Buy and Sell signals do not occur regularly and from the information available it would appear Citi analysts are correct when they talk about "powerful signals". Last time we saw a similar Buy signal was in mid-2010, before that it happened in late 2008 and in early 2009. Last time we saw a Sell signal was in 2008, before that it happened in late 2007. Need I say more?

(Just as an aside, Citi analysts have taken the opportunity to compare their own, proprietary indicator with predictions derived from the VIX in the US. Their conclusions are the VIX's accuracy is hardly better than "random" statistical outcomes, while the Citi Euphoria/Panic Model seems to have a track record worth paying attention to over the past 25 years).

Assuming we are currently not in the "other 10%", Citi's indicator is thus telling us US equities will be higher by year-end, and there's even a higher likelihood they will be higher in twelve months time. The latter comes with a 97% accuracy.

On average, report the analysts, US equities gain 8.9% in the following six months and 17.3% over the twelve months after the Buy signal. But those are averages from the past, and we all know how easily these statistical averages can deceive. Citi's official target for the S&P500 index by end December is 1400, which is less than 5% away from where the index is now. Maybe the conclusion to draw is that a bottoming process is taking place and equities are likely to put in a better performance in the second half than they did in the first?

At the very least, Citi's market indicator confirms similar suggestions by various other indicators. The balance between bears and bulls in weekly investor sentiment surveys conducted by the American Association of Individual Investors (AAII)) in the US is, believe it or not, a widely recognised contrarian market signal. In the first week of June the number of bears nearly beat the bulls by 2:1, which is yet another rare occurrence. Since then equities have recovered somewhat from their lows and, equally important, the balance between bulls and bears in the AAII surveys has now returned to long term averages.

Note that both indicators are signalling a "bottom" at the same time as economic data in the US have ceased surprising to the downside. Sure, there are plenty of other indicators; technical, market breadth, inner-strength, copper, Chinese equities, you name it. The one that caught my personal attention this week, on top of the two I mentioned above, is the so-called "Contraction Watch" by the Consumer Metrics Institute in the US. This Institute is a private enterprise which, independently from official statistics, measures online purchases by consumers in the US.

Thus far, these online purchases only kept falling and falling, indicating the US consumer is in far more dire straits than ever before in modern history, but now the index has slowly started to move upwards. At the very least, this suggests some relief in US consumer related surveys and data in the weeks ahead, which no doubt will add to growing market confidence. Note the improvement thus far is small still, and the Institute itself remains sceptical about whether this improvement will sustain, but only the future will tell.

Bottom line: there are plenty of indications around that equities are building a platform from which higher levels should be seen in a few months' time.

For investors, the best way to benefit from these (hopefully accurate) prospects, is directly linked to the question: what do you want, exactly?

If you are in the market looking to piggyback on the rising tide boosted by improving risk appetite, then energy and mining stocks should definitely be on your radar. Especially with many a resources analyst convinced product prices for producers and miners are poised for a rise between now and year-end. One thing investors should note however, is that the many observations about how equities have underperformed actual commodity prices of late doesn't necessarily mean that equities are in for a sustainable catch-up. As annual increases in prices for natural resources will become much more benign from here onwards, these companies will face increased scrutiny about cost levels, return on investments (capex), funding needs and achieved production increases.

Historically, this is a time when commodities tend to outperform share prices of the producers of these products. Note: I am not saying there is no upside from rising prices, there is, but not to the extent as many observations made by market watchers might suggest.

A prime example of this has recently taken place among future and present producers of LNG in Australia with the market now anticipating these companies will all, to some extent, face delays and higher costs for their mega-projects. This then has translated into share prices for engineers and services companies ("pick and shovel" providers) taking a hit too.

Just as there are many roads that lead a traveller to Rome, investors have many more avenues at their disposal to try taking advantage of rising share prices later in the year. How about taking a look at some of the future champions put forward by stockbrokers and other equity investment specialists? Bradken ((BKN)) is one name often mentioned in this context, another one is Transfield Services ((TSE)). Add Boart Longyear ((BLY)). Amongst smaller cap miners, PanAust ((PNA)) seems to be everybody's favourite now that Equinox is no longer listed. Also, I cannot help but wondering how often CFS Retail Property Trust ((CFX)) is being mentioned.

Also often mentioned -outside the usual suspects such as Rio Tinto ((RIO))- are Amcor ((AMC)) and MacMillan Shakespeare ((MMS)).

Those looking beyond the next rally should not forget that cheap valuations in combination with growing, accumulating dividends beat all of the above over a longer term timeframe. The art is trying to avoid the companies that are yet to be de-rated a few notches further as there seems to be more weakness ahead for large parts of the Australian economy, whether we like it or not.

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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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