Rudi’s View: When Forecasts Are Too High

This story features BLUESCOPE STEEL LIMITED, and other companies. For more info SHARE ANALYSIS: BSL

In this week's Weekly Insights:

-When Forecasts Are Too High
-How Long This Rally?
-Quote Of The Week

By Rudi Filapek-Vandyck, Editor FNArena

When Forecasts Are Too High

One conclusion to draw from the first two weeks of the August corporate results season in Australia is some share prices had been sold down too deeply earlier in the year.

Take BlueScope Steel ((BSL)), for example. On Monday, the company released a better-than-forecast FY22 performance, but guidance for the six months ahead will force most analysts to lower their estimates. Yet post-result, the shares have quickly gained more than 5%.

BlueScope also announced an extra $150m will be added to the running share buyback, hereby extended, which could be a positively contributing factor as well.

Irrespectively, the shares were trading near $26 exactly one year ago and they fell as low as $15, a few times, in July.

FNArena's consensus target is currently sitting underneath $22, implying there's a whole lot more upside potential remaining, on condition that sentiment doesn't sour on the prospect of an economic recession in the year ahead.

On Monday, financial result releases by Carsales ((CAR)) and GPT Group ((GPT)) have equally triggered a notable positive share price response.

But let's not get carried away, Bendigo and Adelaide Bank ((BEN)) reported as well, and its shares are, at the time of writing, down some -8.6% while Beach Energy's ((BPT)) update has seen its shares tank by -12.4%.

It's still very much a heavily polarised market and share price responses in either direction are not confined to your traditional definitions of 'value', 'growth', 'defensive' or 'quality'; not even to 'cheap' or (seemingly) 'expensive'.

Shares in GUD Holdings ((GUD)) have been trading well, well below most price targets set by stockbroking analysts, yet there is no visible momentum whatsoever post the release of FY22 financials.

On initial assessment, it seems GUD slightly missed expectations, with no forward guidance provided.

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The August corporate reporting season is now mid-month in Australia, but in terms of actual numbers the harvest to date is still tiny. FNArena's Monitor (updated daily) still only has 39 results and we are expecting that number to grow to 350 by the first week of September.

I am not trying to be the early party-pooper, but there hasn't been much as yet to draw a lot of positive inspiration from.

Up until a few years ago, reporting seasons used to take off with a number of positive results, but this year's early-season sentiment boost clearly has to come from the likes of BlueScope Steel: companies whose share price has been pulled down too far.

In terms of released results to date, the FNArena Monitor has 46% (18) as reporting in line with forecasts, with beats (11) and misses (10) pretty much on an even keel.

Too early to draw any firm conclusions, though it is my personal view that we have been rather positively-biased when registering Rio Tinto's ((RIO)) result as "in line" and Telstra's ((TLS)) as a "beat" – both could just as easily be called a "miss" and "in line" respectively, which would have tilted the early season numbers towards a negative start.

One added observation is this year's challenging environment is proving more challenging for the weaker operators and for the sector laggards than it is for the leaders, as one might expect.

In other words: it should not surprise market updates by 'Bendalaide' Bank and Westpac ((WBC)) are not of the same robust nature as the updates released by National Australia Bank ((NAB)) and CommBank ((CBA)).

Another observation is that certain perennial underperformers simply find themselves supported by favourable macro-momentum, which helps with glossing over yet another wishy-washy market update.

Insurance Australia Group ((IAG)) comes to mind, though fellow insurers QBE Insurance ((QBE)) and Suncorp Group ((SUN)) didn't exactly exhibit a lot of inherent strength either.

Those analysts retaining a positive view do so predominantly on the insurance cycle, which is thought to be positive for the year ahead. Share price action post-results for these insurers has not been inspiring, to put it mildly.

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UBS strategist Richard Schellbach is more optimistic. He sees early indications of corporate Australia proving more resilient than the sceptics are forecasting. Market updates by the major banks are one prime example of this thesis.

Of course, the obvious contra-comment to make here is the true impact from RBA tightening has yet to be felt and CBA head honcho Matt Comyn, for one, is preparing for a rough twelve months ahead.

To Schellbach's credit, confession season has been fairly mild prior to August and most companies, though they may not inspire higher forecasts or increased enthusiasm, they are still predominantly performing in line with guidance and market expectations.

As expected, analysts are busy downgrading forecasts for the year ahead; a process that already started in the months leading up to August. Schellbach predicts such downgrades are likely to persist over the next six months.

Traditionally, and all else remaining equal, this would form an extra headwind for the market in the coming months.

Market strategists at Macquarie are equally positive after the first two weeks of corporate financials in Australia, noting large caps and financials in particular have managed to generate more positive earnings surprises while free cash flow has generally been better-than-forecast.

Macquarie does acknowledge the low sample to date, plus the fact discretionary retailers and industrial companies have yet to report in large numbers. Inventories could be the extra sting on top of rising costs.

Macquarie also observes 35% of reporting companies to date has guided to growth below 6% in the year ahead. This, the broker highlights, would be below inflation if its own inflation projection for 2023 comes to pass.

One early observation worth highlighting is Macquarie pointing out stocks with high short interest have thus far experienced the best post-result returns.

In contrast to its early reporting season assessment, Macquarie doesn't like the market's set-up with valuations considered high, in particular if that US recession arrives next year, as is the broker's in-house prediction.

Macquarie thinks a lot more downgrades will be needed to pull profit forecasts in line with next year's reality on the ground.

The combination of still-high valuations and forecasts cum further downgrades elicits a rhetorical question from Macquarie: how can this be a new bull market?

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Even more worried than Macquarie about analysts' too rosy forecasts is the team of US strategists at Citi.

On their observation, present bullishness in analysts' forecasts globally has only been matched twice; in 2000 and in 2007. Of course, we all know what subsequently happened; a big bear market opened up and share markets halved in value.

Citi runs a regularly updated Bear Market Checklist, with the strategists explaining this is exactly why (too) bullish analysts forecasts are one of the warning signals on the checklist.

The discrepancy between top-down forecasters and the bottom-up projections by analysts could hardly be more different: the first group is seeing ever more signs of recession ahead, but there's currently no room for such economic contraction in bottom-up forecasts.

Just to be sure: peak bullishness in forecasts does not by default mean share prices will halve in the months ahead. Citi's historical data going back to 1994 shows one other example: 2010-2012. Back then, remind Citi strategists, peak bullishness proved a false signal. Global equities merely traded sideways over the following 12 months.

How do we explain this wide divergence and why is it that bottom-up forecasts are the ones most likely out of sync with reality?

From Citi's report:

"Notably, analysts get the beginning of bear markets very wrong. Instead of turning cautious, they turn even more bullish.

"They do eventually turn more cautious as earnings forecasts fall further, but it is a slow process."

Here's the official warning:

"With prices falling further than EPS downgrades, PE multiples are contracting.

"History suggests that investors should be wary of following this logic."

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Citi's assessment, albeit global, receives two thumbs up from Credit Suisse's in-house assessment of financial conditions in Australia. The RBA's tightening thus far in 2023, explains Credit Suisse, has already amounted to one of the fastest periods of financial tightening for the country.

Now for the bad news (supporting the views of UBS, Macquarie and Citi): history shows financial tightening precedes actual GDP by two quarters, or half a year. This signals domestic GDP in Australia will shrink to below 2% growth by early 2023, and thus forecasts for corporate profits will prove too high.

Credit Suisse estimates the risk to corporate profits in Australia is circa -15% over calendar year 2023. The broker also thinks the RBA is ready to turn more dovish in Q4, which will provide market support when analysts should be busy further reducing forecasts.

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FNArena is in the unique position of having our own data, and history going back to early 2006, which allows us to check data assessments such as the one highlighted by Citi.

On FNArena's Buy-Hold-Sell data, the percentage of Buy (and equivalent) ratings in Australia has seldom been as high as this year, which is one reason as to why I personally have been warning about a bear market this year.

As also expected, with more than 59% in positive ratings, local analysts are issuing more downgrades than upgrades, with downward adjustments to valuations outnumbering increases, as underlying growth projections are coming under pressure.

I can confirm Citi's general observation: these are slow-paced processes. Analysts are using the relative resilience in FY22 performances as a general sign to go slowly on paring back next year's numbers, also supported by relatively upbeat comments from management teams at companies.

While none of these statistics tells us anything about the likely trend in markets in the days, weeks, or even months ahead, they do raise serious questions about today's valuations and calls for a new bull market having commenced.

As per always, successful investing is not about constantly making accurate forecasts. It's about making sure that if a forecast proves wrong, you're not losing shirt and trousers in the process.

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Recent Weekly Insights:

–https://www.fnarena.com/index.php/2022/08/11/rudis-view-august-results-first-blood/

–https://www.fnarena.com/index.php/2022/08/04/rudis-view-august-preview-curveballs-profits-opportunities/

–https://www.fnarena.com/index.php/2022/07/28/rudis-view-im-so-bearish-im-bullish/

–https://www.fnarena.com/index.php/2022/07/21/rudis-views-pre-august-observations/

Transcript of recent interview:

–https://www.fnarena.com/index.php/2022/08/10/rudi-interviewed-august-focus-on-quality/

How Long This Rally?

There's never but one narrative that goes around in financial markets.

And so the irony is that at a time when most economists and forecasters have been convinced that economic recession next year will be extremely difficult to avoid for major economies, share markets put in a fairly comprehensive rally on the prospect of central bankers potentially softening their tightening policies.

As one astute market observer put it (I am paraphrasing now): your brain tells you we're still in a bear market, there's a recession coming, earnings estimates are due downward adjustment, inflation is still too high and central banks are nowhere near finished with tightening, yet our eyes are signalling this market has started to trade like we're in a new bull market that has only just started.

Before we all succumb to the market's newly-found momentum, there are plenty of indications institutional investors are still not convinced.

Analysts at Bank of America (BofA Securities) just reported their clients have been running down cash levels through buying… bonds (corporate and government), while largely shunning equities, except for those private clients looking for income. The latter have been scouring markets for utilities, REITS and financials.

Here in Australia, UBS strategist Richard Schellbach repeated his year-end target for the ASX200 is still 7000.

And while the market seems determined to take every positive as a reason to keep this rally going for longer, Schellbach's view remains

"…equities still face a decelerating economy and earnings downgrade cycle, and therefore the scope for any further gains driven by dovish rate assumption would seem limited."

Plenty of voices around, however, who take guidance from price action and who now have become convinced this market will simply continue to climb the wall of worry, and move a lot higher than the sceptics believe it can.

Personally, I have no Fear Of Missing Out, otherwise known as FOMO, and would be extremely surprised if a new bull market up-trend started in June.

At the same time, financial markets do not always make 100% sense in the here and now, and it's best to keep an open mind. In the end, it's the weight of money that determines where share prices move to, not opinion or rusted-on insights.

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As far as the rally since the June lows is concerned, it remains yet to be seen whether this is nothing but simply a bear market rally, with more weakness on the horizon, or whether the bear market of 2022 is already behind us.

A few numbers from recent data analysis conducted by Longview Economics (having analysed 88 bear market rallies across seven major equity indices since 1996):

-Indices rally on average 13% in bear market rallies;

-Each relief rally on average retraces 65% of the prior decline;

-Relief rallies last on average 37 trading sessions;

-There is strong correlation between the size of the initial decline and the ensuing relief rally;

-Relief rallies at the start of the bear market are more uniform while their size becomes more difficult to predict later in the bear market.

Bottom line: the current up-trend might as well add a few more percentages up until respective 200 days moving averages, and still be within the framework of your typical bear market rally.

Pick your narrative. I am sticking with The Cautious Investor, as I have been since the beginning of the calendar year.

Medium term modeling at Longview is generating Sell signals, which is keeping current positioning Underweight equities and Overweight US Treasuries.

Quote Of The Week

"Once my mindset shifted from 'get rich quickly' to 'build wealth slowly' my returns improved dramatically."

[Brian Feroldi, financial educator & author, Long-Term Mindset]

(This story was written on Monday 15th August, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
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