The law of averages

You can use statistics to prove anything

And that's exactly what I intend to do. With reference to some pretty graphs, some interesting statistics and some very dubious reasoning, I lay out the case for why a June pullback is a definite possibility.


After today's strong close the All Ordinaries index rose 3% for the month of May and represents as shown above the 10th consecutive month on month rise in the index. From July 31st 2006 to May 31st 2007 the All Ords has risen an impressive 28.0%. That sounds like quite a stellar performance so I decided to find out how much of an achievement it really is by plotting the frequency of consecutive month on month rises and declines of all durations over the last 10 years (I chose 10 years because that's all the data I have).


The graph above shows that in the past 10 years 10 months of consecutive gains has only happened twice, the first time from May 2004 - Feb 2005 and the second from Aug 2006 - May 2007. In fact it has happened twice in the past 3 years. Another way to look at it is that over the last 36 months the All Ords has risen in 30 of those months. What's to stop the index rising for an 11th, 12th or 18th straight month? Absolutely nothing, but the law of averages suggests we are due for a pullback sooner rather than later.

So that's it, my whole argument basically comes down to the fact that based on historical performance the All Ords is due for a pullback. Not very convincing I know, especially with the economy a picture of health and looming income tax cuts and SMSF perks post June 30th. Oh forget yesterday's soft retail sales number it was just a blip, and ignore the fact that housing is at it's least affordable in years and that major construction companies such as Lend Lease are predicting the housing slump to continue until the second half of 2008. These things interfere with the orderly procession of a bull market.

US Non-farm payrolls is where the action is

The US brushed off the dip in the Chinese market with the contempt it deserved with the S&P500 and Dow powering on to new highs. As I said yesterday I think the most interesting news this week will be US non-farm payrolls. The ADP report on private sector employment released yesterday showed private sector jobs grew by 97,000 below the long term trend but not disastrous.

The market is estimating 150,000 new jobs to be reported from the labor department on Friday after the lack-lustre 88,000 rise in April. Remember April's number was influenced by a huge birth death adjustment so it will interesting to see not only May's figures but any adjustments to the April number.

All eyes turn to Wall Street

No doubt you've heard the news that the SSE Composite fell 6.5% today triggered by the increase in stamp duty from 0.1 to 0.3%. If you think this was an over reaction you're right. Let's take a look at what a 0.2% increase in stamp duty amounts to. On a trade with a value of 150,000 RMB or approximately 20,000 USD, stamp duty will increase from 150 RMB to 450 RMB or USD $20 to $60. Not exactly shearing away large chunks of wealth.

So what to make of the market's reaction? I believe, and I have absolutely no evidence to back it up, that it demonstrates just how speculative the Chinese market has become. If the stockmarket were full of rational individuals buying stocks on the basis that companies are undervalued (a silly assumption to make in the current market) would a 0.2% increase in transaction costs significantly alter their view of the value of the businesses they are buying?

Here is a quick quiz for you to see if you follow my meaning. If an investor perceives that the price of company ABC's shares are undervalued by 15% and the government raises stamp duty by 0.2%, by how much does the investor think company ABC is undervalued now? If you answered with anything other than 15% and you invest in the stockmarket it might be time to consider putting your money under your pillow.

Following on logically then (warning: applying logic to the stockmarket is fraught with danger) I can only assume that a 6.5% sell-off resulting from a 0.2% rise in stamp duty means many investors aren't investors at all but merely speculators with no idea of value, but hey that's just me.

So all eyes will turn to Wall Street tonight, London is down 1% as I write and NYSE futures are pointing to a lower start. Actually I don't think there will be too much of a sell-off in New York tonight. The real action starts later in the week with US non-farm payroll data to be released.

Beware the double-top
Just a quick glance at a few news sites tonight and a regular theme that keeps getting thrown out is the 'double-top.' From a technical point of view a double-top represents the failure of an index or stock to push through previous highs and continue the upward trend. That's certainly what a few of the major market indicies look like right now, especially the S&P500. Anyway with just 2 trading days left in the month, barring a significant fall May looks likely to chalk up another gain.

I'm going to go out on a limb and make a prediction (I don't often make predictions about market movements because I'm usually wrong) that June will see a pullback in the Aussie market and probably just about everywhere else. Tomorrow I will post some flimsy evidence to support my view. Until then enjoy the action or lack thereof.

CBB finally getting the message

Remember our old friend Cygenics (CYN)? They changed their name to Cordlife and ASX code to CBB. Whilst I don't own any CBB stock I feel it would be remiss of me not to keep updated on the off chance management wake up to the fact that they need to make money - and it seems they may have.

CBB announced 10 days ago that their 'Cytomatrix' technologies have not turned out as expected and will cost a lot more money to bring to commercialization. Thus they intend to bring in outside funding and water down their interest to less than 20%. That will mean writing down the value of their patents to a yet undetermined value. They also plan to close their subsidiary Cytovations Inc which will result in a further writedown of $1.0m.

What does all this mean? Firstly it means that there is a big question mark over management competency after letting these ventures bleed the company of cash for so long. From a financial standpoint annual expenses will be reduced by $3.1m - a definite positive. $1.2m of those are non cash in the form of patent amortisation, the other $1.9m are cash expenses, $0.8m of which is related to the closure of Cytovations Inc. The company lost $6m last year so a reduction in expenses and cash outflow will be welcome however it doesn't get them out of the woods yet.

From the chart below it can be seen that the company is still bleeding cash every quarter. Obviously management realize they can't continue to plow money into businesses and technologies that produce negative returns indefinitely.


FY07 accounts will be a mess riddled with writedowns so it will be impossible to get a clear picture of the more streamlined operation until FY08. Incidentally in 2 years worth of announcements this is the first one I've seen that addressed the issue of profitability, Chris Fullerton, Chairman of Cordlife said:

"This strategy places Cordlife on a firm footing towards profitability and the maximization of shareholder value."

This is a step in the right direction however management still need to demonstrate they can run a profitable business. The mess they made of Cytomatrix and and Cytovations doesn't instill enough confidence for this little black duck to stick his toe in the water just yet

The lowdown on US sub-prime & Housing

The US Mortgage Market - Overexposed and Overrated

The title above links to a very informative article on the state of the US mortgage market. It's quite a long article so if you can't be arsed to read it, I have summarized a few of the main points below.


On the Sub-prime market

• The amount of mortgage lenders that were no longer in business, in bankruptcy or had been bought at distressed prices was 26 in February. Today it is 74.
• About 25% of the mortgages on new homes in 2006 were sub-prime.
• Whilst sub-prime mortgages are not considered investment-grade securities, through the alchemy of securitization and CDO's approximatey 91% are repackaged as AAA or AA investment grade bonds.
  
• Up to 20% of sub-prime mortgages originated in 2005 and 2006 are expected to default and go into foreclosure however CDO's assume less than 1% will default. (hmmm someones not going to be happy)
  
• By the end of 2002 foreign investors owned $235 billion in mortgage backed securities by the middle of 2006 it was $850 billion.
  
• Whilst AAA mortgage backed securities have performed as expected, several BBB rated tranches have lost 25% of their value in 6 months.
• Other than mortgage banks there has not been much damage. Several major institutions have suffered write-downs but their enormous profitability has enabled them to absorb the losses.
  
• With no real systemic distress evident it seems the claim that "its different this time" because the risk has been highly diversified and distributed among many market participants has been a fair call.

On the Housing market

• The housing data is much softer than what is being reported from official channels. An independent analyst has sales down 22% in the year to April 2007 versus the official 9%.
  
• For new home sales the census bureau does not subtract cancellations thus making them look rosier than they are re- the 16% rise in new home sales for April.
• While total foreclosures, at all stages, are up 60-70% over last year so far, foreclosure notices - the front end of the process, when a mortgage is typically 90 days delinquent - are 127% higher so far than in 2006.
  
• Foreclosed homes being resold by banks or lenders are hitting the housing market with an average price drop of 30% nationally.

The article also quoted the commentary by THE BIG PICTURE on the new home sales data that I quoted in a earlier post a few days ago.

More on US Home Sales

US existing home sales for April declined 2.6% to a seasonally adjusted annual rate of 5.99 million, the lowest level in 4 years whilst inventory of unsold homes increased 10.4% to 4.20 million, an annualised 8.4-month supply, the largest supply in 15 years. Consensus was for flat sales.

That is at odds with the previous days' data on new home sales which showed a 16.2% increase in sales and a contraction in inventory from 8.1 months to 6.5 months.

Again we should be wary of reading too much into volatile housing numbers. Anyway here is some food for thought courtesy of THE BIG PICTURE regarding the upbeat new home sales data:

Another Look at New Home Sales

As we wait for the 10:00 am Existing Home Sales Data (I will be on the beach by then) let's have yet another look at the New Homes numbers from yesterday.

Last night, Larry derided our very straight forward analysis of New Home Sales as "tortured logic." As noted yesterday, Homes are not impulse purchases, and double digit single month gains are highly aberrational, typically followed by mean reversion.

If that analysis is not to your taste, consider these other factors:

• The 16.2% jump in April sales was the biggest in 14 years -- as Bill King noted, that should’ve triggered warning bells immediately.

• The rise in sales were due mostly to a "35% surge in ‘homes not yet started.’ Completed home sales were virtually unchanged m/m (31k from 30k).

• About 2/3 of April sales were for homes priced under $300,000.

King's most damning observation about April's New Home Sales data is based on the most recent few years of April data: They ALL have all been dramatically revised downwards:

-April 2006 New Home Sales were initially reported as +4.9%, but were later revised to a
DECLINE of 2.6%.

-April 2005 was initially reported as +0.2% but was later revised to a DECLINE of 5.1%.

And finally, King asks, "How is it that the ‘bad weather’ that diminished retails sales did not affect new home sales?"

I think we already know the answer to that one . . .

I would add that in addition to the 2/3 of homes selling for less than $300,000 the number of houses that sold for less than $150,000 almost doubled.

No doubt tightened lending standards are having some impact on sales, just how long that continues is a case of wait and see.

For whom the bell Tolls

So Paulson was right, we've seen the bottom in the housing market with new home sales up 16% in April. However prices were down 11% indicating builders were discounting to get rid of stock. So is Paulson dreaming or is he on the ball? Difficult to say when the data is so volatile the statisticians have trouble confirming whether numbers were actually up or down for a particular month. They say we need 5 months of data before we can see a new trend emerging so it's probably wise to keep the champagne on ice for a while. Forget about house sales for a minute and let's take a look elsewhere for a clue to the health of the housing market.

How about Toll Brothers Inc. (TOL) whose 2Q07 profit plunged 79% to $0.22 a share from $1.06 per share in the previous corresponding period? The result included pre-tax land write-downs of $119.7 million, or 44 cents a share, CFO Joel Rassman added that:

"Given the uncertainty surrounding sales paces, and market direction and, thus, the potential for and size of future impairments, we are not comfortable giving full earnings guidance at this time,"

So it seems TOL doesn't share Paulson's optimism. Analyst Daniel Oppenheim of Banc of America Securities said he expects additional pre-tax land impairments of $225 million this year, based on continued declines in margins.

You can't really blame the builders for not being more forthcoming with their forecasts since the effect that tightened lending standards will have are yet to be fully felt. Whilst the company believes less than 2% of its customers used subprime loans the CEO commented that:

"the impact of stricter lending standards arising from problems in the subprime market is negatively affecting affordability at lower price points," "This, in turn, can impact the entire 'housing food chain,' including some of our potential customers' ability to sell their existing homes."

On a brighter note and lending support to Paulson's claim that the corner has been turned in the housing market Toll's cancellation rate fell to 18.9% in 2Q07 from 29.8% in 1Q07.

US Home Sales & Goods orders up, markets down

In the US on Thursday Durable Goods orders were up 0.7% in April which, whilst slightly below consensus expectations of 1.0% was made up for by an upwardly revised March number from 4.3% to 5.0%. The Fed's preferred measure which excludes defense orders was up a robust 1.2%.

Turning to housing, new home sales rose a surprising 16.2% in April well above expectations of a flat number. Whilst that might seem wonderful average prices fell 10.9% and inventories declined from an 8.1 month supply to 6.5 months indicating home builders are discounting to get rid of stock. I've noted before the volatility associated with housing data. This article over at THE BIG PICTURE puts it into perspective.

If you ever entertained the notion that markets move in a rational fashion Thursday's action should put that thought to rest. Initially the markets were up - the Dow about 70 points but then the fear of no interest rate cuts seeped in knocking the Dow down more than 150 points to finish 84 points down. So investors are saying they would rather see a slowing economy for the chance of an interest rate rise than signs of a pick-up in the economy which would therefore feed into corporate profits and stock prices - go figure.

PBP - profit guidance update

PBP announced today it expects to post profit before tax of $6m for FY07 which is in line with prospectus forecast s. The company also stated that they recorded record sales in April and expect another record in May.

More importantly PBP gave guidance on the likely impact of the Phoscal claim. The company's preliminary estimate is somewhere in the range of $2.2 - $5.0m but expects the final liability to be materially less than $5.0m because of appeals and a possible reduction in costs yet to ruled on by the court. In addition the company may seek to recoup the final liability against PBP's original legal advisors who they claim did not properly advise Pro-biotec of its potential cost exposure under the Phoscal claim.

Regardless of the outcome of appeals and other claims by PBP I believe it is prudent to factor in a $4.0m abnormal for FY07. Using today's earnings guidance as a base I forceast FY08 NPAT at $6.0m putting my valuation of PBP at $1.15 per share a 15% premium to the share price.



The Phoscal claim is a one-off and the company can cover the liability with its existing cashflow and debt facilities. A liability of $4.0m will effectively wipe out the years cashflow - cashflow that could be used to pay down PBP's already high debt levels.

Today's announcement makes PBP's position a little clearer however with the claimant's substantiation of costs and the appeals process still to come the whole affair will continue to weigh down on the share price. An air of doubt will also remain around the capability of management and rightly so.

Blog tidbits

Herb Greenberg is a fairly annoying character to listen to so that's why I read his blog instead of listening to his webcasts. Yesterday Herb came up with some interesting little tidbits on his blog I thought were worth sharing. The first one takes a look at the all time high level of US margin debt.

Margin and Bubbles -- Not that Anybody Cares

Nifty report today from Portales Partners on brokerage margin debt, which at $318 billion is 14% above its highest level reached in March 2000 -- the year the dot.com bubble burst.

In a note to clients, Portales says one viewpoint is that by retracing 127% of its fall between the market's March 2000 peak and the September 2002 trough in conjunction with a rally in the border indexes, "the worst has been seen."

The report goes on to say, however: "We don't share this sentiment. Instead, we see the rise in margin debt as sign of a revival of animal spirits (i.e., renewed speculation) and desperation on the part of the consumer to maintain their newly found (higher) standard of living. Both represent living on borrowed time (and money)."

The report adds: "The direction of margin debt has been a coincident (not leading) indicator for market direction, but we suspect the current levels may indicate excessive optimism and thus a potential top in the market.)"

For what it's worth....

The second piece may or may not be true but regardless Paulson's comments struck me as very amusing anyway.


Builders Laugh at Paulson?

Recent comments by Treasury Secretary Hank Paulson that the housing slump is largely contained apparently didn't get lost on builders. As the story goes, CSFB analyst Ivy Zelman told her company's sales force today that builders attending the Builder 100 Conference in San Diego laughed when the comments were mentioned as if Paulson didn't know what he was talking about. How did I hear? From a legitimate and well-regarded trader who heard it directly from his Credit Suisse broker after Zelman reportedly broadcast the story on the Credit Suisse Squawk Box. Zelman hasn't returned my call.

Listen to the smart money

I don't know what came over me yesterday publishing a bullish article on the Chinese stock market so here is a return to form with an article warning of red flags being raised by the 'smart money' in Asia.

Chinese food for thought
Commentary: Pay attention: The smart money in Asia is raising red flags

By Todd Harrison

Last Update: 11:16 PM ET May 22, 2007

"Sun-Tzu: If your enemy is superior, evade him. If angry, irritate him. If equally matched, fight, and if not, split and reevaluate."

Bud Fox, "Wall Street"

NEW YORK (MarketWatch) -- In the sixth century, "The Art of War" laid the groundwork for modern-day military strategy. Ironically, it may also be offering sage advice as we edge through the finest times in Chinese financial history.

In the past week, three prominent Far East figures have voiced concerns over the Shanghai ascent.

Li Ka-shing, the richest man in the region, said, "There's a bubble in the China stock market" and, "The high price to earnings ratio is reason to worry." He also cautioned investors against short-term speculation, saying, "They should have learned a lesson from the Asian financial crisis of 1997."

Merrill Lynch & Co.'s China chairman followed suit a few days later, noting that, "it's getting out of control," and, "investors should pare holdings," citing those very same valuations where prices are, on average, trading at 51 times earnings.

Finally, billionaire Lee Shau-kee, chairman of Henderson Land Development Co., opined that Chinese shares trading on mainland markets are at an "unreasonable'' premium to those in Hong Kong, threatening to create "a bubble.''

Smart money, one and all, offering seasoned Chinese food for thought.

To be sure, holders in the region have plenty to digest on the heels of a rally that has tacked on 54% this year and 248% since the beginning of 2006.

There's nothing wrong with meteoric growth, mind you, particular for those savvy enough to have made that bet a few years ago. China is the motor that powers the world economic engine. It is, in many ways, what the United States used to be. That's a blessing, but it may also portend a curse.

When I heard these comments, my mind meandered to the immortal words of Alan Greenspan, who first whispered "irrational exuberance" in 1996. He was prescient but early, missing the meat of the historic stateside blow-off.

That thought is a valid one, as the last phase of the denial-migration-panic trifecta is always the sharpest leg of any market move.

But perhaps there's serendipity or symmetry in the fact that Greenspan has now entered the private sector, placing his chips alongside Bill Gross at Pimco. It seems that everyone wants a piece of the pie, even if the crust is baked in China.

To wit, we've seen alliances emerge, such as Beijing's investment in Blackstone, that seemingly set the stage for a massive transfer of wealth. After all, if the world reserve currency continues to falter, as the U.S. dollar has to the tune of 30% since 2002, foreign accumulation of stateside assets is a logical and necessary progression.

The trick to this trade, from where I sit, is the way that it's postured to the public and executed in private. With foreign holders controlling the majority of our debt, they are, in theory, calling our fiscal and monetary shots.

Ben Bernanke and Hank Paulson are walking a tightrope, with nationalization on one side and isolationism on the other. A swift breeze from either side will bring imbalances to bear, which is precisely the reason that policy makers from both countries are currently meeting in Washington.

We know there is inflation in things we need to power, educate and feed the world and simultaneous deflation in discretionary items, consumed mostly by the debt-dependent U.S. consumer. The goal is orchestrate a gradual transition that allows for stable and sustainable coexistence.

Globalization isn't evil. Quite the contrary, it has allowed emerging markets to assume a larger role in the supply-demand equilibrium. For every action there is an equal an opposite reaction, however, and the other side of that trade is upon us.

The U.S. is no longer the dog that wags the world's tail. That role has been transferred to China and our collective fortunes rest in the decision making process of a foreign power. Again, there's nothing wrong with this as long as we remain aware and prepare ourselves in kind.

Most Americans are quick to dismiss the new world order for fear of being called unpatriotic. The rub is that the process of financial democratization is the very definition of capitalism, the same brand that we've been espousing and projecting for centuries.

I don't claim to know everything there is to know about China but I do know this. If there's one constant across borders and throughout time, it's the wisdom to pay attention to those in the know.

And when the smartest money in Asia is raising red flags, it behooves us all to respect the risk.

Todd Harrison is the founder and CEO of Minyanville.

Relax, China Isn’t Going To Crash

It's not healthy to be negative all the time and even worse to only seek out opinions that agree with one's own. So here is one for the bulls that paints a different picture from the popular China is a bubble waiting to pop crowd.

Relax, China Isn’t Going To Crash

May 22 2007 - Australasian Investment Review – (AIR)

So far this year the Chinese economy and share market have continued to roar ahead.

The Chinese authorities are keen to cool both and this was evident in the latest moves to increase both interest rates and the banks’ required reserve ratios and to widen the daily trading band for the Renminbi.

Some commentators fret that the economy is a bubble, that the share market is a bubble and when it unravels it will be disastrous for the rest of world, including Australia.

The AMP Society's Dr Shane Oliver says there will be few problems with China. Here’s his argument:

He says that as long as he has been analysing China various commentators have been wringing their hands about the sustainability of its strong growth rate.

Many seem prone to see the bright lights of Shanghai and the rapid development all over the country as proof that China is the next Asian crisis. And yet, despite these regular predictions of doom, China’s economy continues to zoom along.

Our view is that China is being propelled by very strong structural forces.

These include strong productivity growth, huge competitive advantages, rapid urbanisation, surging consumer demand and very strong investment.

These in turn are underpinning solid gains from Chinese shares.

With per capita income levels in China still way below rich country levels China’s rapid growth phase has a long way to go, probably several decades.

While recent economic growth remains remarkably strong, eg real GDP up 11.1% over the year to the March quarter, the economy is no closer to being in an unsustainable bubble than ever.

The normal signs of impending trouble in emerging markets are simply not present in China’s case:

Inflation is low, at just 1% year on year excluding food. Since the mid 1990s there has been a dramatic improvement in the growth/inflation trade-off in China, partly reflecting greater reliance on capacity enhancing investment to drive growth.

• The current account is in surplus – as opposed to the huge deficits that preceded trouble in the Asian crisis.

• China is not reliant on foreign capital inflow. In fact, the rest of the world is reliant on Chinese capital outflow!

• Foreign exchange reserves are the world’s largest.

• Unlike the Asian crisis countries the Chinese Renminbi is undervalued, not overvalued.

Furthermore, after efforts over the last few years to re-balance the economy investment is running below previous peaks, it has shifted from the eastern areas to the central and western areas & consumer spending has strengthened all of which is consistent with government policy.

Sure China faces environmental problems and political risks and its managed exchange rate makes it hard to control liquidity but these problems aren’t enough to derail its strong growth prospects.

While the latest tightening measures will act to slow growth they won’t crunch it:

• The base lending rate at 6.57% (up from 6.39%) is well below nominal GDP growth of around 13%, so monetary conditions are still not tight;

• The banks’ required reserve ratio (i.e., the amount of deposits they must retain in reserves) at 11.5% is well below actual reserves of around 13%; and

• The widening of the permissible Renminbi daily trading band against the $US from 0.3% to 0.5% may signal a faster appreciation against the $US, but it’s unlikely to be a dramatic change as the previous band already allowed for a monthly appreciation of 6.8% and yet the Renminbi rarely moved by the maximum permitted and is up only 7.9% since the July 2005 move from a fixed exchange rate.

The timing looks partly designed to lead to smoother talks between China and the US this week.


Just as the gradual appreciation of the currency since 2005 has not had much impact on Chinese export growth (which has been averaging 25 to 30%) it’s unlikely a slightly faster pace of appreciation will have much impact either as China’s cost advantage is huge.

More fundamentally, the trade imbalance between China and the US reflects excess savings in China and excess spending in the US and exchange rate changes won’t fix that.

So, while it’s clear the Chinese authorities want to slow the economy down a bit, they have no need to crunch it and recent policy measures won’t have a major impact.

We are of the view that the Chinese economy is on track for growth of around 9 to 10% over the year ahead.

The structural forces propelling the Chinese economy make it a bit like a car going down a hill. But it is not out of control and the authorities are simply tapping the brakes to make sure this remains the case.

With growth likely to remain strong it’s quite likely we will see further tightening, but it’s hard to see the brakes being slammed on because there is no need.

The Chinese share market is a concern to many, so what is really happening?

So far this year Shanghai A shares are up 50% (after a 130% gain last year) and the Citic/S&P index of the 300 largest companies listed in Shanghai and Shenzen is up 85%.

Individual interest in share investing in China has become huge with 250,000 new share accounts being opened each day compared to a daily average of just 3000 earlier last year.

This rate of increase is clearly unsustainable and many are fretting about a bubble but several points are worth noting.

• Firstly, much of the rebound in Chinese shares since 2005 reflects a recovery from a four-year bear market, during which individual Chinese investors lost confidence in shares and allocated most of their assets to bank deposits.

• Secondly, profit growth for listed Chinese companies over the last year has been a very strong 78%.

• Thirdly, while the price earnings ratio for Chinese A shares of around 40 times is high by our standards it is only just above its 10 year average of 36 times and is well below its previous high of 60 times.

The PE on Chinese shares is also way below the peak levels reached during previous share market bubbles, eg, the Japanese Nikkei index peaked on a PE of 70 times in 1989 and the tech heavy Nasdaq reached a PE of 160 in 2000.

• Finally, Chinese investors still have a very low proportion of their financial wealth invested in shares, around 25% compared to over 50% in Australia and 40% in the rest of Asia. Bank deposits on 3% or so interest account for 65% of financial wealth.

So the long term potential for a higher allocation to shares is high.

Quite clearly the recent rate of appreciation in Chinese shares is unsustainable, and the authorities are keen to cool it down.

This may involve jawboning & administrative measures, like we saw in late February. As such, volatility is likely to be high with corrections inevitable, but the longer term outlook remains strong.

While some worry that a sharp fall in Chinese shares would have a major impact on the Chinese economy this seems unlikely.

While strong long term growth in China helps underpin the Chinese share market over the long term, over the last decade the Chinese economy and share market have moved in different directions.

While shares moved up in the second half of the 1990s the economy slowed, and the reverse occurred from 2001 to 2005.

The relationship between the share market and the economy is far looser than in developed countries because the equity market still only accounts for 10% of financing in China and the share of equities in household financial wealth is very low at 25%.

And given the highly speculative nature of short term moves in Chinese shares a short term swing in either direction is unlikely to tell us anything about the Chinese economy, which for reasons we have already indicated is likely to remain strong.

For these reasons if there were to be another sharp correction in Chinese shares like that in late February; there may be a knee jerk reaction in major global share markets, including Australia’s.

However, since it is unlikely to signal problems in the Chinese economy any impact is unlikely to be sustained.

Copyright Australasian Investment Review.
AIR publishes a weekly magazine. Subscriptions are free at www.aireview.com.au

The Black Swan

Forget about the Chinese stock market bubble, the US housing crisis or waning corporate profits, the real danger is the black swan

Markets will never spot the black swan

Dangers such as tension over Iran and a flagging US economy are being ignored

Larry Elliott, economics editor
Monday April 30, 2007
The Guardian

These are curious times. In the middle of last week, the Dow Jones Industrial Average (DJIA) powered through the 13,000 level for the first time. At just about the same time, the dollar's value against a basket of global currencies was at its lowest since the demise of the Bretton Woods fixed exchange system.

In the UK, the Bank of England expressed concern about the increased risk-taking in the City and the exposure of heavily borrowed private equity groups, in the week that a titanic struggle began for control of the Dutch bank ABN Amro. The Royal Bank of Scotland, in cahoots with its Belgian and Spanish partners, is mounting a £49bn hostile bid for ABN to prevent it falling into the hands of Barclays. That's an awful lot of money to pay for any company, although not quite as much as AOL agreed to pay for Time Warner in January 2000.

Article continues
In retrospect, the Time Warner/AOL hook-up was seen as the moment the boom of the late 1990s over-reached itself. It was, according to those with 20-20 hindsight, a moment of hubris. Anybody with a brain in their head could see that the only way for the stock market at the turn of the millennium was down. The intriguing question now is whether the battle for ABN marks a similar high watermark for the current boom. As the Bank noted in its Financial Stability review, the reward for taking on risk is currently at very low levels, for the simple reason that investors perceive little risk. "That has increased the vulnerability of the system as a whole to an abrupt change in conditions," the Bank said.

So what could go wrong? Certainly, the macro-economic backdrop is less favourable than it was. Interest rates are going up across the world - in China, New Zealand, Britain and the Eurozone. In the US they are on hold and are unlikely to come down until later in the year. Japan, where there were renewed signs of deflation last week, is the exception. Near-zero borrowing costs in Tokyo are the source of global speculation since they allow investors to borrow cheaply in yen and take punts in countries where interest rates are higher.

It's not just that, though. The American economy is slowing, as the GDP figures released on Friday clearly showed. A fall in the value of the dollar, while necessary to reduce the US trade deficit, will add to imported inflation, already rising as a result of higher Chinese prices and oil at close to $70 a barrel.

Nor does the geopolitical situation look that clever. Kofi Annan was in Berlin last week to lambast the laggards of the G8 for their failure to keep promises made to Africa at Gleneagles two years ago. What went unnoticed was Annan's view that a broadening of the Middle East conflict to Iran risked sending oil prices to $120 a barrel. Despite its travails in Iraq, the Bush administration is still taking a hawkish stance over Iran's nuclear ambitions; military action - air strikes rather than an invasion - is still an option.

And yet the stock markets float serenely upwards, as if they had not a care in the world. The great and the good of the financial markets have a rationale for this, which goes as follows. Share prices are high because corporate profitability is high. Corporate profitability is high because the global economy is growing rapidly, with demand more evenly spread around the continents than it was three or four years ago. There may be risks out there, but these risks are both discernible and quantifiable. The chances of a serious market disruption are, therefore, extremely slim and the likelihood is that stock markets will ride out any short-term problems caused by a touch more inflation or slightly tighter monetary policy.

This is a comforting analysis. It may also be hugely complacent. Nassim Nicholas Taleb certainly thinks so. His new book, the Black Swan, is a fascinating study of how we are regularly taken for suckers by the unexpected. Why Black Swan? Well, apparently, before the discovery of Australia it was assumed that all swans were white because nobody had ever seen one of a different shade. It took only the sight of one black swan to disprove a theory based on millions of previous observations.

Taleb argues that there are three attributes of a Black Swan. The first is that they lie outside the realm of regular expectations, with nothing that has happened in the past able to point to its possibility. The second is that they have a huge impact. The third is that despite being unforeseeable, human nature means we construct convincing explanations for the appearance of a Black Swan once it has happened.

Markets tend to work on the basis that Black Swans either don't exist or appear with such irregularity that they are not worth worrying about. As a result, traders in the City of London went home on the night of August 3 1914 seemingly oblivious to the fact that a world war lasting more than four years would start the next day. Similarly, there was not the slightest suggestion on Friday October 16 1987 that the Dow Jones would lose more than 20% of its value the next Monday. The Nobel prize-winners Robert Merton and Myron Scholes, who put together Long Term Capital Management and convinced their investors that their models made it a sure-fire bet, had failed to factor in the possibility of a Black Swan - in the case of LTCM, the Russian debt default in August 1998.

Taleb is a fan of the Polish-born French mathematician Benoit Mandelbrot, who gives short shrift to those who believe financial markets resemble a bell curve, with modest movements the norm and violent moves infinitesimally rare. Looking at the daily movements of the DJIA from 1916 to 2003, Mandelbrot said that according to the neat bell curve analysis, there should have been 58 days when the Dow moved more than 3.4%, when in fact there were 1,001.

Instead of just six days when there were movements of more than 4.5% there were 366. Only once in every 300,000 years should there have been a day when the Dow moved by 7% or more, but it happened 48 times. "Extreme price swings are the norm in financial markets - not aberrations that can be ignored. Price movements do not follow the well-mannered bell curve assumed by modern finance; they follow a more violent curve that makes an investor's ride much bumpier," Mandelbrot says in his book The (Mis)Behaviour of Markets (Profile Books). "A sound trading strategy would build this cold, hard fact into its foundations".

At the moment, it seems highly unlikely that this "cold, hard fact" has been built into market thinking, where the abiding sense is that this is forever summer. That, of course, is precisely Taleb's point. If Captain Smith knew the iceberg was there, he would have avoided it. If I knew what the next Black Swan was and when it was going to glide into view, I wouldn't be doing this job. If a Black Swan was predictable it wouldn't be a Black Swan, but the fact that markets can see only white swans suggests that the shock - if it comes - could be profound.

· The Black Swan, £20, is published by Allen Lane

Bernanke on Housing

In response to the cooling housing market and news that 44% of banks were tightening their lending standards Fed reserve chief Ben Bernanke told at conference at the Chicago Federal Reserve Bank that:

Curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters,"

He predicted increases in delinquencies and foreclosures this year and next as adjustable-rate loans face interest-rate resets. Whilst admitting that the housing market slump had been an important source of the slowdown in the economy he added that:

"we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."

Again we come across this grey area, how significant does it have to be to be regarded as significant? Difficult to quantify and a question I'm sure Bernanke doesn't want to touch. He went on to say that:

"Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market." "The troubled lenders, for the most part, have not been institutions with federally insured deposits."

Sen. Charles Schumer had the audacity to question Bernanke's confidence

"I hope that Chairman Bernanke is right when he says that a slumping housing market will not affect the broader economy, but I would not bet the house on it,"

Also of interest was where Bernanke laid the blame for the sub-prime meltdown. It seems exuberance over home prices, intense competition for lending, increased securitization of mortgages, and delusions and misrepresentations by lenders and borrowers alike were the culprits. Hmmm, funny there is no mention of the Fed's role in deflating interest rates to artificially low levels and printing money hand over fist to encourage the aforementioned evils. Bernanke went on to outline the tough job the Fed has:

"Regulators must walk a fine line," "we must do what we can to prevent abuses or bad practices, but at the same time we do not want to curtail responsible subprime lending or close off refinancing options that would be beneficial to borrowers."

The first line almost sounds like an attempt to take some responsibility but that is quickly swept away by next line. Well to prevent abuses and bad practices how about trying to promote real economic growth rather than inflating asset prices through paper speculation?

US Housing starts up permits down, IP up

US housing starts rose 2.5% in April versus expectations of a 1.5% decrease whilst building permits fell 8.9% to 1,429k their lowest level in 10 years and the biggest % decline in 17 years. It must be remembered the housing data are relatively volatile, the standard error for housing starts was plus or minus 9.3%. Thus a 2.5% raise is indicative of not much at all.


Building permits are more reliable with a sampling error of plus or minus 1.4%. Since permits lead housing starts and are generally less volatile more weight should be given to that number. The housing slump is now into it's 19 month from it's peak in late 2005 with no signs of a recovery anytime soon.

Still the market didn't let the housing data get it down rallying on stronger than expected Industrial production numbers. IP rose 0.7% versus expectations of a 0.4% rise. Increases were recorded across all major market groups in April. Manufcturing rose 0.5% prompting some analysts to conclude that manufacturing is turning the corner. Where have I heard that line before?

US retail woes

With the US consumer up to his eyeballs in debt and paying gas prices not seen since Katrina it seems he has little left for his favourite pastime of consuming.

US retail bellwether WalMart Stores Inc. (WMT) posted 1Q07 profit of $2.83 billion up 8% from a year ago in line with analysts forecasts on slightly lower than anticipated sales of $86.41 billion. This doesn't sound too bad and it isn't, especially when compared to some other retailers that have reported profit declines this quarter (read below for Home Depot and Limited Brands profit drops). However a closer look at the numbers paints a less than rosy picture of the company's US operations. Management pointed out the exceptional growth in International operations with sales up 19% in the quarter and which now account for 23% of total sales. Some back of the envelope calculations reveals the following:


Management stated that profit growth from International operations outstripped sales growth. From this we can conclude that Wal-Mart's domestic profit growth was less than the 5.7% in domestic sales growth. Thus Wal-mart's bottom line profit growth was at best 5% for domestic operations. Wal-mart also revealed that all important same stores sales growth for the quarter was an anemic 0.6% for US stores. Remember that Wal-mart is in the midst of a US$10 billion buyback (currently $3.3 billion left to go) that is lending support to earnings per share. Looking ahead the company forecasts 2Q07 earnings in the range of 75 - 79 cents a share against market consensus of 79 cents. If April's sales decline (Wal-marts biggest in 28 years) was anything to go by the company could well be hitting the bottom of that range.

Elsewhere Limited Brands Inc. (LTD) slashed its 1Q07 earnings forecast by 50% on Tuesday and said that it is selling two-thirds of its Express stores division to a private-equity group in a cash deal valued at $548 million, while it looks at "strategic options" for its namesake stores. Due to report on May 23rd the company restated its first-quarter profit projection in the range of 12 cents to 14 cents a share from an initial range of 25 cents to 28 cents a share, as sales and margins stumbled at all its divisions, but particularly at the Victoria's Secret chain. Looking forward the company expects 2Q07 to "continue to be challenging"

Home Depot (HD) is feeling the pinch from the faltering US housing market posting a 30% decrease in 1Q07 profit. For the full year the company expects to come in at the low end of their already low forecast profit growth range of between 4% - 9%.

Aust wages growth still behaving

Despite unemployment at a 33 year low Australian wages growth has been fairly well behaved. Today the ABS reported that wages grew 1.0% in the first quarter of calendar 2007 coming in well under the 1.3% consensus estimate and up 4.1% on a year earlier, even after factoring in the minimum wage rises awarded in March. The $AUD fell and bonds rallied as lingering fears of an interest rate rise were alleviated in the short term.

Also of note today was the Westpac consumer confidence survey showing consumer confidence at it's highest level in 32 years. Evidence of happier consumers showed up in the March retail sales numbers and with the recently announced tax cuts and positive interest rate outlook we can expect more positive readings over the next few months. The real test will be to see this new found optimism showing up in the currently lack-lustre housing market. All things considered I must concur with recent observations that the Australian economy is currently in a sweet spot.

US CPI, Housing sentiment

The headline CPI number in the US increased 0.4% slightly less than the 0.5% increase expected in April. The core number was on target recording a 0.2% rise and bringing the annual gain down to a one year low of 2.3%. Some analysts registered surprise at the soft numbers pointing to the continued housing slump as the culprit. As far as interest rates are concerned it may relieve some pressure on the need to raise rates but it is hardly a case for rate cuts just yet as they remain above the comfort range of the Fed. Looking at the last three months the rate just sneaks into the Fed's comfort zone at 1.9%.

Speaking of housing, homebuilders confidence as measured by the National Association of Home Builders (NAHB)/Wells Fargo housing market index fell 3 points matching a 16 year low set in September 2006. These figures cast serious doubt over some economists assertions that we have passed the worst part of the cycle. NAHB's Chief Economist David Seiders commented:

"The crisis in the subprime sector has infected other parts of the mortgage market as well as consumer psychology, and as a result the housing outlook has deteriorated,"

Seiders went on to say that he doesn't expect any improvement in housing sales or production until late this year. Let's hope the "containment" and "past the bottom of the cycle" camp don't hear of David's blasphemy.


Above is some other interesting data released by the Fed on Monday showing that banks are clamping down on subprime lending and on so-called nontraditional loans such as interest-only loans, option adjustable-rate mortgages, and no-documentation mortgages. According to the Fed, at least 43% of domestic banks tightened their mortgage lending standards in 1Q07 up from 16% in 4Q06. As shown below this represents the largest tightening in the 17-year history of the survey.

Asian bubble trouble

Yes I've joined the chorus of pundits warning of the impending bubble that is reaching exponential proportions in China. I came across an interesting article over at Market Clues on the state of the Shanghai stock market worth pondering. If the following doesn't sound like a bubble I don't know what does.

China Stock Bubble About to Burst

It appears that the bubble in the Chinese stock market is finally becoming a concern as Goldman Sachs is warning that:

"It is now a critical time for the government to take action and prevent the excess from building up further."

Here are some interesting factoids about the Chinese stock market:

* The total value of all stocks on the Shanghai Exchange exceeds the value of all other Asian stock exchanges combined -- including Japan, the second largest stock exchange in the world.

* The Shanghai Index has quadrupled in the last 22 months.

* PE Ratios are in the 40-50 range.

* Goldman Sachs economist Hong Liang said new stock account openings in the month of April totaled 4.79 million, exceeding those of 2005 and 2006 put together. About 17% of total accounts were opened in the past four months.

* Beijing is aware of the risks, and over the weekend, Gov. Zhou Xiaochuan of the People's Bank of China told reporters that he, too, is concerned about a possible bubble forming in the stock market.

If it were possible to let the air out of a bubble slowly, of course that would be the right course of action. However, at this stage of overvaluation, that's not possible. Probably the only way the government could prevent a crash is to shut the market down completely for some period of time (say, a few years). That isn't really practical and would likely be a cure worse than the disease. There's really nothing good that can come out of the situation, so just expect a crash sooner or later.

The last time the Shanghai market had a 10% correction in February, it quickly pulled the rest of the stock markets around the world down with it. Since then, just 3 months later, Shanghai is now 33% above the level it reached before that correction, after having pulled stocks higher along with it worldwide. No doubt, a much large correction will happen this time and it will have a much stronger impact on the rest of the planet's stock markets. In fact, it may have already started. And, it will come at the worst possible time for the US stock market, which has been pushed to an extreme of overvaluation by Yen-carry loans to fund private-equity buyouts of public companies and massive share buybacks by corporations.

The US market fell sharply Thursday. More troubling was the fact that option speculators bought call options on the dip. Normally, option specs buy puts on dips because they expect the market to continue down. Only very rarely are they so bullish as to actually buy calls, expecting the market to immediately turn around and rally to a new high before those calls lose a substantial amount of value (options are a wasting asset which decay with every tick of the clock and if a market doesn't move quickly in the "right" direction, they fall in value). In fact, we can only recall one other time when the option speculators bought calls on a dip. That dip was the one which followed the absolute high in the S&P 500 Index in March 2000. If the market is able to rally back here to a new high -- and we certainly wouldn't be surprised by such behavior -- it would indicate that the top being built now is a larger degree top than even 2000. And, of course, we know that last top was followed by an 80% decline in the NASDAQ.

Aussies not deterred by interest rates

The Australian Bureau of Statistics released data today showing a seasonally adjusted 63,335 loans for owner-occupation were agreed to by banks and home lenders in March, the highest level since July last year. First-time home buyers now make up 18.2 per cent of all financed dwellings, the highest level since April 2006. Importantly the biggest and until recently most sluggish NSW market posted it's third monthly increase in a row.


It appears many Australians are determined to own their home despite three interest rises in the last 12 months and given the tax cuts that will kick-in post June 30th many more may be enticed into taking out a home loan. Another rate rise at the RBA's May meeting was squashed by subdued inflation data however the strong employment data released last week along with the latest housing stats put interest rates back in focus again. Attention will turn to wages growth which has been surprisingly subdued given the tight labour market conditions. Any sign that the inflation genie is escaping the bottle may force the RBA's hand in the coming months.

PWK raises $16m

PWK came out of a trading halt today announcing that they had raised $16m through the placement of 5,000,000 shares with institutional shareholders. Together with the recently ANZ debt facility the company now has access to close to $40m in capital. Last week I stated that this gave a green light for project Runway, In a nutshell, I was wrong. The placement was done through Wilson HTM corporate finance and thus as ANZIB have been appointed as the financial advisor for project runway these funds were raised for other reasons:

"the directors believe that the company is very well-placed to take advantage of strategic opportunities such as the proposed international fibre network to Guam (project Runway) and to leverage its considerable fibre optic network and internet peering base and partnerships with new domestic and international products."
If that all sounds a bit vague to you I agree. The announcement stopped short of giving the green light to project Runway. In a phone call with the CFO today he stated that the funds could certainly be used to 'kickstart' project runway or they may be used for other emerging opportunities. He reiterated that the board is very confident with the progress made on project Runway to date however because of the considerable size and cost of the project they want to get all their ducks in a row before making an announcement to the market.

The next few months is shaping up as an interesting period for PWK. The market is anxiously awaiting the green light on project Runway. Also as alluded to today PWK is looking at other growth opportunities and we should expect an earnings guidance update for 2007 sometime in the near future as well.

Aussie economy coasting despite housing

Housing approvals which seemed to be climbing out of a slump rising 9% in February fell 11.4% in March and are down 9.6% in the year to March 2007. Whilst a small rise of 0.1% in private sector housing approvals was recorded other private sector dwellings fell 29.2% reversing the 25.6% gain in February. In dollar terms total building approved fell 3.7%, to $5,471.5m, in March 2007. Declines in dollar value occurred across all categories - residential, non-residential and additions and alterations. Homebuilders AV Jennings and Australand both singled out New South Wales as the laggard. So the much anticipated recovery in housing has been put on hold, at least for another month.

However despite the weakness in housing the rest of the economy remains strong as it enters it's 16th straight year of expansion. Whilst Inflation has dropped back into the middle of the RBA range, new jobs continue to be created without causing a blowout in wages and consumers are spending like crazy. Just take a look at the latest retail sales numbers for March released by the Australian Bureau of Statistics last Tuesday. Sales were up 1.1% from February, twice the consensus forecast. From 1 year ago sales were up 8.2% in dollar terms. Department stores were the main beneficiary as confirmed by David Jones which reported a third-quarter sales increase of 8.4% the day after the ABS release.

On employment the Australian unemployment rate fell to a 33 year low of 4.4% as 50,000 new jobs were created in the month of April as against a consensus estimate of 20,000. Regardless of the easter effect in March the employment and retail statistics combined with a lower inflation reading paint a picture of health for the Australian economy. It is worth bearing in mind that housing and inflation are usually considered leading indicators whilst unemployment a lagging one. Both the housing and inflation data seem to support one another pointing to a slowing in the economy and whilst its a little early to say employment has peaked it's difficult to see the unemployment rate falling further.

US same stores growth lowest in 37 years

To say US same store retail sales growth for the month of April was soft would be an understatement. In fact, there was no growth as measured by the IBS International Council of Shopping Centers sales tally which posted a decline of 2.3 percent, the biggest drop since the index started tracking the data in 1970. Furthermore negative same store sales growth during the same period have only occurred on two previous occasions - April's being by far the sharpest. Retail bellweather Wal-Mart (WMT) reported a same stores sales decline of 3.5% - its deepest decline in 28 years.

Then yesterday the Commerce department released it's retail sales figures for April. Consensus was predicting a 0.4% rise in retail sales, the number disappointed falling 0.2%. Remember the Commerce Department figures contain gasoline sales which spiked to their highest levels since the disruption caused by Hurricane Katrina, excluding gas the decline was 0.4%. Read the full report here.

You'll be happy to know that economists are in agreement that the worst is now behind us, if you are laughing incredulously at the preceeding line you are not alone. Also the market took heart in the evidence of a slowing economy because of the possibility of interest rate cuts. I've commented before on the twisted logic that says interest rate cuts are good. Whilst it's true that interest rate cuts make equities more attractive relative to bonds, When interest rate cuts are bought about by a slowing economy and two-thirds of that economy's growth is driven by the consumer what do you think is happening to corporate profit growth?

On retailers earnings, 1Q07 is looking fairly robust, remembering that the Easter sales period was included in March numbers. If April is any guide 2Q07 earnings for retailers are looking soft. If we haven't passed the worst of the economic downturn as economists would have us believe and get a continuance of soft retail and housing numbers during 2Q07 we could be getting very close to the use of the forbidden 'r' word. In case you are wondering that forbidden word is recession.

PWK to go ahead with project runway

Whilst it hasn't been formally announced today's request from Pipe Networks for a trading halt due to a capital raising can only mean one thing - that they are proceeding with 'Operation Runway'. This is no surprise as previous announcements had indicated that the company had significant support from both domestic and international carriers. PWK is aiming to transform the economics of the Australian internet and telecommunications market by building a new submarine cable linking Sydney to the key international telecommunications interconnection hub at Guam.

PWK have etimated the price tag at somewhere between $180 - $200m - more than their current market cap of around $140m. Last week the company announced a new $20m debt facility had been established with ANZ so the capital raising is expected to be significant, much bigger than their intial IPO offering. Management have consistently said they will not proceed with the project if they cannot produce the high returns on capital they currently earn. Considering the size of the project, estimated to be complete by calendar 4Q08, the project runway undertaking will significantly transform the company into a major telecommunications infrastructure provider domesticly and to a lesser extent abroad.

I expect a healthy appetite for PWK scrip from institutional investors and hope that management give current shareholders the opportunity to top up their existing holdings and take part in the next growth phase of the company.

Buybacks prop up US earnings

1Q07 earnings season has surprised to the upside and looks set to continue the trend of double digit earnings growth. According to Zacks latest report with more than three-quarters of S&P companies having reported median year over year earnings growth is tracking at 9.8%. Healthcare (+15%) and Materials (+14.3%) are the star performers whilst Telecoms (-6.7%) Utilities (2.5%) and Techs (3.1%) the laggards. Zacks revisions ratio stands at 1.59 for FY07 which means analysts are making many more upward earnings revisions than downwards and across all sectors. The ratio is even higher for FY08.

On a total earnings basis even despite recent upgrades earnings growth for S&P 500 stocks is expected to be around 8% for 2007, half that of 2006 levels. Interestingly Zacks draws attention to the effect buybacks are having on earnings growth. In 2006 $432 billion was spent on buybacks by S&P 500 companies contributing an estimated 3.5% to earnings growth with a similar contribution expected for 2007. That would place underlying earnings growth by S&P 500 companies at around 4.5%. Hardly inspiring numbers.

My Portfolio: 6 month return

It hasn't been the best of months for my portfolio falling 16% from a month ago and sending the total return over six months into negative territory whilst the All Ordinaries rose another 4% over the same period. PBP's share price continues to suffer as uncertainty remains with respect to the legal claims being made against the company. PWK has drifted as the market awaits news on the fate of project runway.


I keep rambling on each month about the pointlessness of measuring performance over short times frames with a long term investment philosophy. At least that's my excuse for now, however in 6 months time I'll have to come up with a different one as it won't be valid. Thus in keeping with my philosophy I'll only publish these numbers every quarter from now on. However the performance of my portfolio can always be checked by clicking the My Portfolio link at the top right of the page.

QAN deal fails

The buyout consortium, Airline Partners Australia (APA), failed to keep the Qantas deal alive as they were unable to get 50% acceptances from shareholders by last Friday. Now remember the bid was for $5.45 per share an approximately 35% premium to the pre-bid price of around $4.00. Yes the company is experiencing excellent trading conditions and is on track to post record earnings this year and next. However even bearing that in mind I struggle to justify the pre-bid price of $4.00 with fair value at around $3.77 per share.

The valuation below assumes QAN can continue to provide a ROE at the historically high 16.7% rate forecast in FY08 - a big assumption given their fairly average returns of around 13-14% over the past 5 years. If you're wondering why ROE doesn't show more improvement over the forecast period that's because on average over the last 4 years QAN has raised $200m of new capital each year. A discount rate of 16% reflects QAN's high debt levels. Taking debt into account return on funds employed is a mediocre 12.7%.


This is a low return, highly geared, highly capital intensive business operating in an industry with poor economics. Despite favorable market conditions QAN does not present an attractive investment opportunity at pre-bid prices of $4.00. Even if you don't agree with the above valuation would you reject a 35% return on your money today as opposed to the chance of a 35%+ return in the future in such a poor returning business? Richard Branson was once asked, "How do you become a millionaire?" He replied:

"Start off as a billionaire and then buy an airline"

Updates, follow-ups and other stuff 4

Weak Jobs data fails to dent momentum - The slowdown in the U.S economy finally showed up in the payroll data with non-farm payrolls increasing just 88,000 in April ( Economists had estimated a figure of 100,000) and the unemployment rate rising slightly to 4.5%. A closer look at the detail of the report reveals an even greater underlying weakness than the headline number suggests.

* The April number is the weakest in 29 months and has averaged 129,000 this year opposed to 225,000 at the same time last year.
* In the separate household survey, employment plunged by 468,000, the most since November 2002.
* The unemployment rate rose to 4.5% from 4.4%, but the increase would have been larger except 392,000 potential workers dropped out of the labor force altogether, the biggest decline in the labor force in nearly four years.
* The average workweek declined, and total hours worked in the economy dropped by 0.4%.
* Average wage growth was tepid, rising just 4 cents to $17.21, a 0.2% gain. Wages are up 3.7% in the past year, well off of the peak of 4.3%.

But that was not enough to stifle the market's enthusiasm rising for the 23rd time out of the last 26 sessions (I read somewhere this hasn't happened since 1929) on the back rumored M&A activity between Microsoft and Yahoo, a suspected bid for Reuters and talk of a private equity bid for BHP Billiton. A question no-one seems to ask is, what does is all this activity or at least the rumor of activity actually create? Sorry silly question to ask in a bullmarket.

US 1Q07 Earnings- Despite some weak economic numbers in April it must be acknowledged that 1Q07 earnings have been surprisingly robust. With three-quarters of S&P500 stocks having reported the median growth rate is 10.1% whilst for the broader S&P 1500 (S&P 500, S&P Midcap 400 and S&P Smallcap 600), median growth is running at a 9.5%. If the current trend continues we may yet get another quarter of double digit growth. Analysts had predicted growth of 3-4% which always seemed overly pessimistic however it might just be that they were a quarter too early. With retailers yet to report it will be interesting to see their numbers and commentary on the effect that higher oil prices have had.

RBA on hold indefinitely, go the yen! - The RBA kept interest rates on hold and considering the relatively benign economic data over the last two weeks they didn't have much choice. They also revised down inflation expectations for 2007 smack bang in the middle of their preferred range of 2-3% at 2.5%. However looking to 2008 & 2009 the RBA expects inflation to pick-up again closer to 3%. I don't share the RBA's optimism, a US led slowdown is only just beginning and will filter through to the Australian economy and financial markets in 2008, but hey, what do I know?

Quote of the week - undoubtedly goes to Mike Whitney of counterpunch for this gem on the state of the US stockmarket:

The Dow is like a drunk atop a 13,000 ft cliff; inebriated on the Fed's cheap "low-interest" liquor. One wrong step and he'll plunge headlong into the ether.

You can read the full, very informative article here

All important Jobs

Positive news outshone the negative again yesterday in the US on the back of news that factory orders were up 3.1% in March against an expectation of 2.2%. The negative, private-sector jobs rose by only 64,000 in April, the weakest monthly growth in four years.

A couple of months back I listed a number of major US firms laying off workers. According to outplacement firm Challenger Gray & Christmas job reduction announcements by major U.S. corporations soared by 44% to 70,672 in April representing an 18% increase from April 2006 and the first time since September 2006 that layoffs rose on a year-over-year comparison. The Challenger figures only cover a drop in the ocean of those that lose their jobs each month. The latest figures from the labor department show that a total of 1.2 million workers were discharged from their jobs involuntarily in February

On Friday the Labor Department will release the all important non-farm payrolls report. Expectations are for a modest 100,000 gain in employment. Housing and employment are two of the best indicators of the health of the economy. With housing looking pretty sick, poorer than expected employment figures will not bode well and it may be to much of a negative for the market to ignore.

Accentuate the positive

At least that seems to be the attitude of the market at the moment. After a raft of lacklustre economic data April ended as the best month for the Dow Jones Industrial Average since December 2003 stacking on 5.7%.

On Monday the Dow closed on another record high after the ISM factory index rose to a yearly high of 54.7%. The ISM is considered one of the best real-time indicators of the health of the economy. A measure above 50% means business is getting better, a number below 50% indicates things are getting worse. Out of 18 industries 11 reported expansion prompting Ian Shepherdson of High Frequency Economics to say:

"If sustained, this would cast serious doubt on our view that the economy will slow further,"..."The next ISM is now of critical importance to the bear story."

Meanwhile the National Association of Realtors reported that its pending home sales index fell 4.9% in March, more than 10% lower than a year ago and to its lowest level since March 2003. Not exactly positive news but as seems to be the trend of late the market soldiers on unfazed.