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Rudi’s View: Dissecting The Next Share Market Rally

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | May 24 2023

This story features CSL LIMITED, and other companies. For more info SHARE ANALYSIS: CSL

By Rudi Filapek-Vandyck, Editor

Dissecting The Next Share Market Rally

Despite all the ups and downs, the noise, the tribulations, the angst and intermittent periods of violent market volatility, the share price of Australia's largest biotech, CSL ((CSL)), is effectively unchanged from three years ago.

Whether this is a positive, or not, depends entirely on one's views on markets, investing and what likely follows next.

My personal view is that CSL's sidetracking since 2020 is almost entirely explained by the macro forces that have since dominated global equities; from covid, to lockdowns, to the outbreak of inflation, and the subsequent major reset in global bond yields, including the post-lockdown recovery trade and this year's economic slowdown.

Throughout the fog of today's slow-moving share price stasis, I see a long-term wealth generator whose valuation and operational momentum are once again aligned for a break-out to the upside, exact timing unknown.

Within this context I note CSL shares have risen circa 24% from January last year, and they are up 5.8% in 2023 thus far (last Friday).

Taking into account company-specific dynamics, the share prices of a number of healthcare stocks on the ASX do not look fundamentally different from CSL's trajectory, again emphasising the all-dominant macro influences for the sector throughout the past four years.

History suggests periods of relative stability in the CSL share price do occur, on occasion. It happened between 2002-2006, with the global industry oversupplied, and again from 2008 till 2012.

The latter period was quite impressive as it includes the GFC meltdown. Most importantly, both periods of stability saw the share price subsequently rally to fresh all-time record highs, and beyond.

The combination of all of the above suggests today's set-up could well turn out very favourable for patient shareholders and newcomers.

To add an extra cherry on the proverbial cake, most healthcare sector analysts seem to agree with that positive view, as are a number of investment strategists across the financial industry locally.

Having closely observed the Australian share market for more than two decades, I cannot recall ever seeing CSL popping up in as many Model Portfolios and Conviction Buy Lists as is the case this year.

CSL share price 2020-2023 (May 22) – source: ASX.

CSL Is Not Robinson Crusoe

There are many other stocks listed on the ASX whose share price today is similar to where it was in 2020 or 2021. The difference entirely depends on whether the shares initially sold off because of covid, or whether they functioned as a safe haven throughout the initial phase of the pandemic.

All four of Australia's major banks, for example, have not gained anything extra once the recovery rally into 2021 had been completed. Luckily, for loyal shareholders, Australian banks are among the world's best and most reliable when it comes to paying dividends, but the broader context for this sector doesn't look half as promising as for CSL.

Australian banks, with notable exception of CommBank ((CBA)), are still continuing their lost decade post-GFC. Shareholders who own the shares since 2007 have only enjoyed the twice-yearly dividends, plus franking tax benefits.

In the case of ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) they also had to endure a fair degree of capital erosion.

Two of the banks -ANZ and Westpac- are arguably caught inside a long-term, downsloping channel since that memorable, final hurrah share price rally for the sector up until April 2015.

Despite bank shares lagging the broader market this year, there aren't many analysts who are genuinely confident and positive about the sector's immediate prospects. Moreover, an oft-quoted market commentator such as Bell Potter's Charlie Aitken, who's uber-bullish on the 'new bull market' for local equities, still advises investors to dump their bank shares.

It is Aitken's view local banks will simply add a second lost decade to their share price performances. Can the sector leading CBA withstand gravity a second time around?

Cyclicals In The Spotlight

More surprising, maybe, given economies have not faltered and inflation remains too high for comfort, is the same observation also applies to large cap resources companies, with a sideways trajectory of approximately two years.

As all kinds of commodities indices and benchmarks peaked around mid-2021 and since have trended south, it should be of little surprise the share prices of BHP Group (BHP)), Rio Tinto ((RIO)), Fortescue Metals ((FMG)), Santos ((STO)), et cetera are all showing similar post-peak trends.

The commodities segment is much more diverse, so here the differences between share prices inside the basket are a lot larger, but many large cap producers globally are equally moving inside a sideways trending pattern.

Recent research by Longview Economics suggests this might signal a bad omen for the sector overall.

Longview's analysis of historical data involves an equal-weighted index of share prices for US cyclicals, comprising of energy, financials, consumer discretionary, materials and industrials. Such an index has been flat over the year past, as well as flat since late 2021, the researcher reports.

History suggests such prolonged periods of sideways movement for this index are subsequently followed by weakness, as shown on the graphic below.

On Longview's data analysis, the current sideways-moving period is the sixth since 1996. All five previous occurrences eventually saw the index fall to much lower levels, implying share prices were simply biding time before the next Big Sell-Off.

Equally important: Longview notes not all pullbacks for US cyclicals are equal in duration and severity with the Fed response seen as the dominant factor. In mid-cycle downturns, the Fed's policy adjustment is typically modest, and thus markets adjust swiftly and revert back into cyclical uptrend-mode.

In case of a US recession, however, the process takes a lot more time and the Fed's response is much larger in magnitude. This scenario tends to go hand-in-hand with much deeper sell-offs with overall sector weakness lasting longer before the next uptrend commences.

Longview's analysis provides no comfort for investors generally as on each occasion, whether cyclicals sell off mildly or more severely, the broader S&P500 index is pulled down substantially lower, regardless.

Longview also concludes that if US equities are poised for significantly higher levels, as suggested by some, its analysis suggests this will be achieved through technology and growth stocks instead.

Shorter-term, however, Longview's own technical and momentum indicators are flashing warning signals, indicating the uptrend in technology and growth stocks, short-term, looks overstretched.

The Pause That Triggers Relief

Thus far in 2023, global equities, including in the US, have refused to succumb to more dire forecasts.

While the Dow Jones (DJIA) is only narrowly positive since January 1st, the S&P500 year-to-date is up 9%-plus and the Nasdaq almost 21%. In comparison, New Zealand's NZ50 index has gained circa 5.50%, while the ASX200 is up less than 3.50%, held back by heavyweights banks and energy.

Arguably, uncertainty relating to the political games being played in the US as the Biden government approaches its debt ceiling is weighing on markets and risk appetite generally, so any positive resolution is likely to trigger the next risk-on rally higher.

Another source of ongoing investor optimism relates to the fact central banks, including the RBA and the Federal Reserve, are closer to a pause in their inflation-targeting tightening policies. Applying the same logic as with the US debt ceiling: a pause in rate hikes with the next move likely to see interest rates being cut might logically be seen as an important risk-on event.

Those investors and traders preparing for the next rally can fall back on a number of historical precedents, including late 2018 when the Federal Reserve changed course and markets rallied for months thereafter. Another prime example is 1994 when risk assets and bonds first paid the price of relentless Fed tightening, but once it stopped, a multi-year bull market phase opened up.

The problem here is that simply relying on such turning points from the past seems too simplistic. Plus history shows those two examples are the exception, rather than the standard outcome. What ultimately defines whether markets can rally, and continue moving upwards in a sustainable manner, is the broader context in the background of these policy turning points.

For example: in both examples of 2018 and 1994 central bank tightening had not led to an inverse yield curve for US government bonds. Such an inverse curve happens when longer duration bonds offer a lower yield than bonds closer to expiration. This is also seen as the classic signal an economic recession is on the horizon.

An economic recession, no matter how short or how mild, would likely still challenge earnings forecasts and valuations in today's markets. It would provide the thus far missing piece in, for example, the aforementioned analysis by Longview Economics. The US bond market this time around is significantly inversed, and has been for a long while.

Historic Differences Matter

Recent research released by analysts at Morgan Stanley has come to a similar conclusion. The research has identified nine significant Fed rate hike periods since 1974. On average, the time between the final rate hike and the first Fed cut is approximately 106 days (let's call it 3.5 months).

Only four of the periods between last hike and first cut produced a positive return for US equities, but those returns averaged an impressive 18%. One can see where any enthusiasm stems from! Also, in only two cases -1989 and 1995- did the market bottom before or coinciding with the first rate cut.

The research points out in both these cases markets had already pulled back significantly in advance; a point that is harder to make in today's context.

This leaves seven cycles when markets did not bottom out until 270 days, on average, post the final rate hike. The average drop in US equity indices for those seven instances is -23%.

The research suggests investors should not necessarily blindly follow the signal provided by US Treasuries, with economic and financial conditions equally important. Alas, including these in today's analysis do not improve the overall picture.

Morgan Stanley suggests unemployment is too low, inflation is too high and leading indicators are running firmly in negative territory. And when it comes to financial conditions and lending standards, the current banking stresses that have appeared in the US are causing a further tightening in credit availability, or worse.

Both in 1989 and in 1995 financial conditions were already improving from extreme stress when the Fed stopped hiking, points out the research. In 2023 conditions are worsening, and poised to deteriorate further. Though, admittedly, Morgan Stanley acknowledges US financial conditions overall remain loose, but they're getting worse, not better.

Morgan Stanley analysts also don't see a positive outcome from the US debt ceiling negotiations: if an agreement is reached that involves significantly reduced spending, as demanded by the Republican opposition, this will worsen the economic slowdown.

If, on the other hand, the US government is allowed to raise additional capital (through issuing bonds) this will drain liquidity from the system, which is equally a negative.

It's A Process!

In summary, while equities at face value have ostensibly surprised through stoic resilience thus far in 2023, still supported by positive technical set-up, underlying the financial and economic fundamentals continue to suggest a more conservative and defensive portfolio positioning seems warranted.

At the same time, investors should always keep in mind not every stock is equally affected, nor to the same extent, and there are always exceptions within sectors and baskets.

A common thread through institutional and professional portfolio views this year has been an emphasis on corporate characteristics such as "quality", "yield", "defensive", "strong operational momentum", and "structural growth". Analysis of historical precedents corroborates such preferences.

Investors should take note, and incorporate this to the best of their abilities in their portfolio and personal strategies. It is true the future is never set in stone, and surprises do occur from time to time, but successful investing is usually closely aligned with paying attention to risks and adjusting accordingly, not with keeping the fingers crossed and hoping for the best.

The process to contain inflation has been an elongated and enthusiasm-sapping process, and it's still ongoing, but one should never lose sight that this too shall pass, eventually. Nothing is forever, nothing stays the same. Patience remains the secret ingredient for share market longevity.

The FNArena/Vested Equities All-Weather Model Portfolio has 23% in cash and 5% in gold, with the largest portfolio holdings concentrated around Aristocrat Leisure ((ALL)), CSL ((CSL)), Telstra ((TLS)), HomeCo Daily Needs REIT ((HDN)) and NextDC ((NXT)).

The All-Weather Portfolio selects stocks from the curated lists that are 24/7 available to paying subscribers:


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(This story was written on Monday, 22nd May, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(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. All views are mine and not by association FNArena's – see disclaimer 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: contact us via the direct messaging system on the website).

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