Daily Market Reports | Aug 25 2015
By Greg Peel
The Dow closed down 588 points or 3.6% while the S&P lost 3.9% to 1893 and the Nasdaq fell 3.8%.
Don’t Panic
The important point to note here, before the inevitable comparisons are made with 2008, is that this is not a financial crisis.
There is a risk of currency crunches in smaller emerging markets putting pressure on cheap US dollar loans, there is a risk of emerging market oil producer countries coming under enormous fiscal pressure, and there is a risk that a wave of marginal US oil producers will default when oil price hedges roll-off shortly, pressuring US lenders.
But the same US banks that needed to be rescued in 2008 are now sitting on mountains of cash. Systemically important banks around the developed world, including the Big Four in Australia, are loaded with capital. If we look at this from the perspective of what is causing the panic across global markets, it is not China per se, even though China is a root source of the issue. It is Wall Street.
Is a manufacturing PMI of 49.1 the end of the world, particularly when China’s economy is transitioning towards a much greater service sector contribution (PMI>50) and consumer-driven GDP? No. Is an 8.5% drop on the day for a laughable casino known as the Chinese stock market, in which a very small proportion of the Chinese population invests, reason to run screaming? No. But what is alarming is when Wall Street falls over 500 points (to use the Dow as the reference) after several steep falls and then backs it up again last night, when in theory the US economy is currently one of the positive drivers among the major global centres.
With the exception of the energy sector, there is nothing wrong with US corporate earnings growth at present. What is wrong is that for three years in a row, Wall Street rallied 15% when earnings only rose 5%. This represents “multiple expansion”, empirically measured as increased price to earnings ratios, which imply investors are prepared to pay more for the same level of earnings than they did the year before. PE increases reflect sentiment, not reality. So if sentiment turns…
After the three years of rally from the US debt ceiling correction of 2011, this year has seen Wall Street top out into a stationary range. Despite constant talk of the market being long overdue a correction, investors have stoically held out on the expectation the reality would catch up with the sentiment. But from a global perspective, which plays into Wall Street earnings, it hasn’t. And the Fed wants to raise rates.
The sentiment had to give, meaning PEs had to come down. This is what we are now witnessing. The only problem is, it’s happening at a speed that is putting the frighteners through the market. And fear begets fear.
Technical Test
The Australian market has not rallied back from the GFC depths to the same magnitude of Wall Street, given the drag of a long period stuck with an overvalued currency. Therefore our PEs have not been as overly elevated, but that’s never going to be enough to stem the immediate panic of days like yesterday on Bridge Street.
It seems like an irrelevant aside right now but one may recall there is a local result season currently underway. At around about the halfway mark (on number of reporting stocks, not time), the FNArena Result Season Monitor is showing a beat/miss ratio of 1.5 to 1, and a broker ratings upgrade/downgrade ratio of 70/26. Now, stock analysts look at the micro picture of stocks and their sectors (bottom-up) and not the macro of overlaying global economic conditions (top-down) and one might suggest these upgrades may look a little foolish right now, but the point is there is nothing wrong with Australian corporate earnings at present either.
Yesterday’s 4% plunge saw every sector finish well into the red, but the emphasis was on the cyclicals while defensives “outperformed”, as they should during such times of panic. Energy copped the brunt with a 6.2% fall, and materials chimed in with 4.6%. At the other end of the scale were consumer staples, down 2.8%, healthcare, down 2.3%, and utilities, down 1.7%. By rights the telco should be defensive and the banks should fit somewhere in the middle, but unfortunately in market cap terms when you sell Australia, you must sell these big names. Hence telcos fell 3.0% and banks 4.6%.
The technicals come firmly into play at such times and here we note the ASX200 initially tried to recover early in the session after support at 5100 was breached, only to be swamped again as the Shanghai market opened. That level gave way without a fight and so the next level to watch was the oh so very familiar 5000 – the level that for such a long time was the brick wall of resistance through which the index would not pass until finally breaking through in 2013.
Yesterday the ASX200 marked an intra-day low of 5001 before closing slightly higher at 5014. The futures are suggesting we can kiss what should be a cement floor of support goodbye today, as the SPI Overnight closed down 181 points. But it may all come down to Beijing.
Beijing Phone Home
Despite a 500 plus point Dow fall on Friday night sparked by the weak Chinese PMI, Wall Street traders were convinced Beijing would respond with fresh monetary policy initiatives – rate cut, RRR cut or both – on the Sunday as the authorities have typically done at such times. But this didn’t happen. That’s why Australia was down 4% yesterday and Wall Street opened down over a thousand Dow points last night.
Fear was exacerbated by yesterday’s 8.5% plunge in Shanghai, which indicated Beijing’s Plunge Protection Team was also absent. What is Beijing playing at? Was the currency devaluation meant to be the final hurrah of stimulus? Or is the Chinese government again caught like rabbits in the headlights, set to react only when panic sets in?
It is understood Mr Obama was last night on the phone to Mr Xi.
Wild
The thousand point opening plunge for the Dow last night lasted all of five minutes. European stock markets were on their way to 4-5% losses but on Wall Street the smart money – mostly institutional investors according to commentary – said this is a great buying opportunity. Of particular note is that at this stage, the S&P500 had booked its long-awaited 10% correction.
At lunchtime, after Europe had closed, the Dow was almost back to square. There followed as wild a ride as any experienced around September 2008. Up, down and all around, it was the weight of sell-on-close orders that finally pushed the average to its second consecutive 500-plus point fall.
On Friday night Wall Street closed on its lows. While commentators are cautious in saying it, last night it looked like a capitulation trade. The session that suggests the bottom is near. But the caveat remains Beijing.
Reinforcing the argument that what we have seen in a week is simply the US stock market correcting rapidly, rather than slowly as it should have done on falling commodity prices and indications all year long that China’s economy was slowing, and on Fed rate rise speculation, is that the reaction in the US bond market was muted.
The US ten-year yield closed down 6 basis points at 2.00%. That is not the stuff of panic, or a flight to safety. Unlike the US stock market, the US bond market has been pricing in slower than expected global economic growth for some time.
Currency markets nevertheless saw further flights to safety. The US dollar index is down 1.5% to 93.37. The Aussie is down 2.4% to US$0.7146. When the dust settles, that is going to look very positive for the Australian economy.
We have seen a flight to gold but the flipside at such times is a need to sell other assets to cover stock market margin calls. Gold is down US$5.20 to US$1155.10/oz.
Commodities
The serious pain was felt in commodities, despite the fall in the US dollar. It must be remembered that volumes on commodity exchanges are thin at present due to the northern summer, in which end-user intermediaries are absent and speculative trading rules the roost.
Aluminium fell 1%, copper 2%, zinc 2.5%, lead 3%, tin 5.5% and nickel 6.5%.
Iron ore fell US$2.30 or 4% to US$53.30/t.
West Texas crude fell US$2.21 or 5.5% to US$38.02/bbl. Brent fell US$2.71 or 6% to US$42.62.
The next words you will hear with regard material and energy sector stocks around the globe will be “consolidation” and “rationalisation”. This time smaller producers are not going to make it.
Today
The SPI Overnight closed down 188 points or 3.7%.
There are a lot of earnings reports out today, but that’s probably not important right now.
An expression that hasn’t been heard for a while, that was popular to the point of tedium in 2008, is “Don’t try to catch a falling knife”. Calling a bottom is fraught with danger. And when it is in place, and confirmed, there will still be plenty of opportunity to buy at much lower valuations.
Don’t panic.
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