Rudi Interviewed: Tough February

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It has become the 'unofficial' tradition in recent years: an interview with Livewire Markets ahead of yet another corporate reporting season in Australia. Below is a sub-edited transcript from last week's interview, released this week by Livewire (also available on YouTube).

James Marlay: Since early October the ASX200 has rallied a stunning 17% to the highest point in February. Straight off the bat: is this still a bear market or a rally with more positive long term implications?

Rudi Filapek-Vandyck: It'll depend on one's definition. We all tend to get more excited when share prices rally and we get more optimistic about the future. But I would caution that after a return of that magnitude which, let's call it out, has surprised most people in and around the market, such a strong rally is going to colour the February reporting season.

It will have a massive impact. Needless to say, company reports will be judged differently from when markets were still -17% lower. It's good for investors to keep this in mind. The benchmark for company results to exceed has now been reset. The bias has shifted. At the depths of last year, companies would be given a lot more leeway. Right now, I think companies will have to prove why share prices should still go higher.

Early indications are in most cases companies that release financial results see their share prices weaken, in some cases quite significantly so. While it's still early days, I think this trend may well dominate this season.

James: We'll touch on that trend in a bit more detail later on. I want us to revisit some commentary that we covered in our last interview (August last year). Back then it was your view that commodities were not recession-proof. I bring it up as we can all see today that the commodities component of the market has been very strong and a big driver of the market's recovery. Have you been surprised by the strength in commodities and what's the impact of China re-opening for Australian commodities?

Rudi: Similar to what has happened with equities in general, I think commodities have rallied ahead of fundamentals, and the China re-opening is part of it. The other thing which I think is very important to note is that the process of raising interest rates, higher bond yields and then the impact on the economy has been much slower than history would suggest.

Markets are not patient. They are not going to sit around and wait for things to happen. So the obvious observation is that the direct correlation between an economic slowdown, economic recession and commodity prices weakening is usually a pretty solid correlation. The problem thus far is, of course, we haven't seen any recessions just yet; we have hardly seen economies slow down.

This is an important part of the picture that is weighing over this reporting season. Some of the corporate results will look absolutely fantastic. But the question remains: what comes next?

For commodities, yes, they've all rallied and the fact that the slowdown is arriving in a much slower manner than one would expect has given investors a lot of leeway to put a lot more risk in markets, but there are still question marks out there. If we look at bond markets; bond markets essentially are forecasting a significant slowing in economic activity.

Whether this will result in a recession or not, we will have to wait and see, but markets don't wait around. Having said so, it may well be given the re-opening in China that even if we still see massive slowdowns in places like Europe and the US, the prices of commodities might remain well supported. I do think the commodities space will splinter. Not every commodity will hold its own.

Another observation is that I did make the forecast last year that oil would not hold above US$100/bbl, and that has proven correct. This hasn't translated into a similar pullback for share prices of producers. This is not that unusual. It happens on occasion.

Needless to say, at some point this gap has to be corrected. Either one goes down or the other goes up.

If those two explanations are not sufficient, I can always fall back on the old joke about economists. What's an economist? That's someone who makes erudite forecasts and then later on explains in that same erudite manner why those forecasts have been inaccurate.

It's very difficult to make forecasts in a market that is all but normal, definitely not textbook. As investors, we always have to be mindful that things change along the way. Will we avoid recessions? I don't know. But I would not be cocky about it because share prices have rallied.

James: Let's dig a little deeper into what I think is a good read on how you're feeling about markets. Twelve months ago, you were holding 30% in cash. When we last spoke in August, that had reduced to around 20%. What's your cash position now and what's the reasoning behind it?

Rudi: I have done remarkably little. I checked this morning, the cash level (in the All-Weather Model Portfolio) is slightly below 18%. From memory, the last thing that happened was buying extra shares in NextDC ((NXT)) when the share price looked ridiculously low. The Portfolio has done nothing else. The reason for that is that I remain skeptical about the fundamentals underneath this rally. The other reason is I expect this reporting season to be brutal at times, and this means you can jump on opportunities.

James: You mentioned you hold a healthy level of skepticism. What are some of the reasons? What are the big things that support your position?

Rudi: Because it's such a slow, ongoing process. Maybe the best comparison to make is with an example from real life. If one asks the billionaire and the homeless guy how did you end up where you did? They usually give the same answer: it happens very slowly and gradual for a long time, and then all of a sudden it accelerates.

My suspicion is we are in a similar process. We're all getting very optimistic because consumer spending is holding up and company results are not falling off a cliff. But central banks continue to tighten and the full impact from last year's rate hikes still has to come through. I think time will come when we might see things deteriorate rather rapidly.

I have a suspicion this is also the view of central bankers, which is why the Federal Reserve is injecting liquidity in the system, and China's doing the same.

As I said earlier, yes, share prices can rally and investors are taking a big leap in that fundamentals will catch up, but there are some big question marks that still need to be answered. To my surprise, which I suspect has also surprised many locally, the increase in the RBA cash rate has not yet been fully passed on by the banks to mortgage holders. Let's see what the impact will be when that happens.

James: Nearly every sector is in the green this year. Last year was effectively all about materials and energy. Small caps have also been resilient. What's your interpretation of these moves? Do you think the market is now looking through the great hiking cycle you are referring to?

Rudi: I think the big rally can partially be explained by market positioning. Many an investor last year was positioned for much worse times ahead. Forecasts were for a very tough first quarter, with improvement likely further out. This rally has now put everything on its head. Some people might draw a direct correlation with central banks and liquidity.

The market is supposed to be forward looking, but it's not perfect in what it does. Human nature, how we are built and operate, is that we become optimistic when share prices go up, but share prices arguably were quite beaten down. So from the moment share prices start moving upwards, money starts flowing in.

The current situation requires that fundamentals catch up with prices. Either that, or share prices have to come down. We will see both in February, and that process can be brutal.

James: We've had a few early reports and as you alluded to, the trend has generally been for negative market responses despite what looked from your analysis and your reading relatively okay results. Can you explain what you've observed and how you think that plays out through the rest of the season? Maybe you can give a couple of examples?

Rudi: I think there's a big difference between the laggards and those companies that have performed well, either in the past weeks or throughout last year. That second group, I think, is now being treated more harshly by investors. You saw that with results from the likes of Nick Scali ((NCK)), ResMed ((RMD)), maybe even Amcor ((AMC)).

There have been a few exceptions, such as Janus Henderson ((JHG)) and Suncorp Group ((SUN)). Suncorp hasn't genuinely participated in last year's market and it is now getting the benefit of the doubt. While others are basically being punished for the little things that may not be perfect. Sometimes this comes down to cost inflation, which is very difficult to forecast from outside the business. Not even management teams themselves can often put a finger on what is likely to happen.

This is not something that just applies to financials or industrials, or healthcare, it applies across the board. In January we saw production reports coming out and many mining companies showed difficulty with containing costs. We've seen few mining companies update early in February. One is an iron ore miner (Champion Iron ((CIA))) and the other is IGO ((IGO)). In both cases share prices weakened. In both cases cost inflation was one of the key ingredients.

This signals it's very difficult to know in advance how investors will respond to financial results.

James: Let's talk some names. Which are the companies you are expecting to deliver strong results, which we don't know whether that's a good or bad given how the market is responding. But tell me some of the names that you're interested in, and follow closely?

Rudi: I think it's important to emphasise the dynamics for this season will be different from what normally applies. What happens usually is that if you're surprising to the upside, you get rewarded. Your share price outperforms sometimes for up to four months. And the opposite holds true as well: you disappoint and that can linger for months.

I think this time around dynamics will be different because we have that Sword of Damocles hanging in front of the market that things might still look good right now, but what about the second half? What about the third quarter?

Having said so, because of the work I do at FNArena, I see a lot of research passing by and that allows me to pick up when sentiment clearly improves towards a given company. Over the past few weeks sentiment has noticeably improved for CSL ((CSL)), also a laggard from last year as the share price hasn't done much. This is why the CSL share price is no longer around $270.

Another stock for which sentiment has improved is Telstra ((TLS)). Last time Telstra actually increased its dividend and very few were anticipating that. It appears from research since then that, overall, dynamics for the telecom sector on the ground have only further improved. Indications are this might further improve in the second half and beyond.

Why is this important? Because if we are preparing for tougher times ahead, then companies like Telstra will become more attractive, because they move in the opposite direction operationally.

Next, the company I already mentioned, Suncorp, is widely regarded as the undervalued insurance company. This doesn't explain everything, but it does explain why this insurer can release a wishy-washy result and the share price goes up. I would be surprised if that share price does not keep on going up in the next few weeks, or months.

Another interesting thing to point out about last year's laggards, and this is a comparison that very few investors make, is that we all get excited about copper and lithium as they are, apparently, in a long term beneficial trend. So we're more than just excited about this prospect and prepared to own those companies for the longer term.

It's not too far out of the ballpark to make a similar comparison to many of the high quality, sustainable growers in Australia who each have a super-cycle that helps and supports them. That has helped those companies over the past decade and it will continue to help them in the years ahead.

Many people still have to get their head around this. Today's opportunity in the share market is not necessarily with PE ratios on three, or eight, or thirteen. The opportunity can be with a stock that is trading on a PE of 30 and beyond. Now we are talking about REA Group ((REA)), Seek ((SEK)), Carsales ((CAR)), even Pro Medicus ((PME)), TechnologyOne ((TNE)), CSL and ResMed, Breville Group ((BRG)) even, and Goodman Group ((GMG)).

Some investors have this misconceived idea these companies have not yet de-rated, but they have. We had a massive de-rating of multiples last year, but it hasn't hit every segment of the market in the same way. There's an illusion that a stock like CSL, which essentially moved sideways, hasn't de-rated, but it has. Last year was a big bear market which only didn't show up at the index level in Australia.

I'll be definitely watching these stocks, in particular as they have participated in this year's strong rally. I wouldn't necessary jump on board at current levels, but if weakness kicks in at some point, I am certain I am not the only one who's looking to get on board.

James: Final question: what does it take for you to reduce your cash to, say, 10%, or lower? Is it down to share price movements or an external factor that increases your confidence that we've moved through the worst of the impacts from the tightening cycle?

Rudi: It will probably be a combination of the two. Confidence should not necessarily come from how markets behave. But it's difficult because the market doesn't always cooperate, it doesn't always present the opportunities when people would like to see them.

Assuming equities don't continue rallying, the market has two choices; either move sideways for a while, or revisit the low. In the second scenario, hopefully we'll all be more keen to allocate more money than in the first. But we can only make assumptions and the market will ultimately decide where the opportunities come from, and how to allocate one's money. We have to be flexible.

James: Thanks for coming in today. Always good to catch up.

(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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