Saturday, 30 August 2008

XAO Finishes Up in August

The XAO had its best month since April rising 3.6% for the month and defying my expectations of further falls. I can't say I'm surprised, I don't profess to have any special insights into short movements of the market, nor does my investment philosophy depend on them. However, it does provide a bit of entertainment.

As mentioned here before, a typical characteristic of bear markets are short sharp rallies that ultimately fail. On the graph below I've identified two major rallies that ended in lower lows. However since the bottom in early August, we really haven't gotten a sharp powerful rally. That's not to say that we need to have one, but that it makes it more difficult for me to make the case for a reversal in September.

What I would like to see is a sharp clearing rally, the rally from the early August lows has only taken the index up 6.8% so far. Something in the order of 10 - 15% would make me feel better about calling for a correction. Of course, events won't play out the way I want them to, but there may be a catalyst for stocks to rally next week.

From a fundamental perspective, the almost certain decision by the RBA to cut the cash rate by 25 bps could spark a rally and if, as some expect, the RBA cuts 50 bps, the market can expect a nice bounce.

However, regardless of the monthly moves my fundamental position that the XAO will make lower lows as we go forward remains in place and that RBA rate cuts, whilst they may provide the impetus for short term clearning rallies, will ultimately fail in a environment of general asset deflation, just as the US Federal Reserves cuts did.

So what then for September? Data from the last 24 years suggests that September is not the best month for stocks but neither is it the worst. The XAO has risen 14 times or 58% whilst declining 10 times.

I'm expecting a rally of sorts in September and then a drop off on entering October as the reality of third quarter weakness in corporate profits and economic growth both domestically and overseas sinks in. However I expect the rally to hold it's gains long enough for the XAO to finish up in September.

And don't forget to have your say and vote in this month's poll at the top left of your screen. Poll will stay open until Tuesday afternoon.

Friday, 29 August 2008

Is Dell the Canary in The Coal Mine for Tech?

Whilst many sectors of the US economy are either in outright recession or are experiencing a slowdown, the technology sector has for the most part remined unscathed. Yesterday courtesy of Dell we saw some signs that growth in technology is slowing, not just in the US but abroad. From Bloomberg:

Dell Drops on Signals of Europe, Asia Spending Slump

Dell Inc., the world's second-biggest personal-computer maker, fell as much as 12 percent in European trading after saying the U.S. slump in technology spending has moved abroad.

If the drop holds in the in U.S., it will be the biggest in nine months. Dell said yesterday that ``continued conservatism'' from some customers in the U.S. is spreading to Western Europe and some Asian countries.

Sales growth in those areas slowed last quarter, and profit missed analysts' projections after Dell reduced prices, particularly in Europe, cutting into profit margins. Chief Executive Officer Michael Dell has sought to shrink the gap with Hewlett-Packard Co., the leader in global PC shipments, by spending more to form retail partnerships around the world...

...Second-quarter net income fell 17 percent to $616 million, or 31 cents a share, from $746 million, or 33 cents, a year earlier, Dell said in a statement yesterday. Sales for the period ended Aug. 1 advanced 11 percent to $16.4 billion. Excluding costs for job cuts and other items, profit was 33 cents, short of the 36-cent average projection compiled by Bloomberg.

Thursday, 28 August 2008

UK Home Prices Continue to Plunge

A couple of months back I noted on a previous post on UK Home prices that you should expect year over year price declines to exceed -10% before the year is out. Once again I've been too optimistic. UK home prices fell a further -1.9% in August bringing the year over year decline to -10.5%.

According to Nationwide, the average price of a UK home fell almost £5,000 in August. Home prices are down -11.5% from the peak in October 2007. Unlike the Case-Shiller index in the US, the trend in the UK doesn't look like slowing.

Whilst declines are only approximately half of what has been seen in the US, the UK declines have reaccelerated. Year over year declines could easily top -15% by the end of the year.

Is Australia poised to follow suit? Remember US home prices peaked on a national level around the middle of 2006, UK home prices didn't peak until October 2007. ABS data suggests Australian home prices peaked on a national level sometime in the first or second quarter of 2008. If double digit declines are in the cards for Aussie home prices, we're unlikely to get confirmation of it until well into 2009.

Wednesday, 27 August 2008

US House Price Declines Slow - Case Shiller

Case Shiller Home Price indexes continued their record declines in June, the 10 city composite showing a year over year decline of -17.0% from a year earlier and is now down -20.3% from the peak whilst the 20 city composite showed a year over year decline of -15.9% and is now down -18.8% from it's peak.

However the year over year declines have begun to slow. The 10 and 20 city index year over year declines increased by a mere 0.1% in June. As the Case Shiller report suggests:

Record year-over-year declines were reported in both the 10-City and 20-City Composites in June; however, they are very close to the values reported for May. The rate of home price decline may be slowing. For the month, the 10-City Composite was down 0.6% and the 20-City Composite was down 0.5%. While still falling, these are far less than the 2-2.5% monthly drops seen earlier in 2008.

Let's be clear here, prices are still falling on a national basis, however the rate of those declines is slowing. Although as the cliche goes (and this one cliche I agree with ) all real estate is local. Again from the report:

In June, nine of the 20 cities were up month-to-month compared with seven in May. Nevertheless, not one market is showing a positive return over the past 12 months and seven of the metro areas are reporting declines in excess of 20.0%.”

So it's not all bad news on the US home price front but nor is it time to break out the champagne and sing happy days are here again.

Also of note yesterday was the release of New Home Sales data. The headline showed that sales increased 2.4% in July, in contrast to a decline expected by economists. However the increase is only after the June number was revised down substantially. So the actual number of sales recorded in July was lower than market expectations.

Again I will reiterate that the revisions to prior months are a better read on new home sales than the current month's data which carries an 11.6% margin of error. Anyone want to have a guess what direction July will be revised to next month?

The chart below comes from calculatedrisk - the best site on the web for US housing analysis. It shows that the actual number of sales (not seasonally adjusted) was the worst July on record since 1991. CR sums this graph up well with this line:
As the graph indicates, there was no spring selling season in 2008.

The good news from the New Home Sales report is that unlike the existing home sales data, inventories are coming down as shown below by the number of new homes for sale.

So what to make of all this? Firstly US home sales and prices are still falling, however the rate of decline is slowing. Also on the bright side, new home sales inventory is coming down. However we are far from a recovery in the US housing market and still not at a bottom in terms of either prices or sales, although there are tentative signs that we are edging closer to that reality.

One more observation, and this is with respect to the Australian Housing market. There is much optimism, a lot of it based falsely on the idea that the Australian housing market is different, that RBA rate cuts will spur a frenetic Spring selling season in Australia. As we saw in the United States this year, there is good evidence to suggest that will not materialize.

Tuesday, 26 August 2008

Australia's Coming Housing Tsunami

I used to think I was on the bearish side. 12 months ago, most would have seen my views as extreme. The more I read recently the more I seem to be drifting back to the middle. Take the following article on Australia's pending housing tsunami as an example:

The Land Down Under Is Going Under

It doesn’t matter how many surfers there are in Australia—the coming surge of home foreclosures and bank failures will pulverize the economy. No one will be able to ride out this wave.

It’s not so easy to get a loan in Australia these days. For the first time in years, the cost of borrowing is going significantly up. That’s not good news if you are trying to buy or sell a house. It’s not good news for Australian banks heavily invested in the housing market, and it is not good news for the economy.

When credit markets tighten and the cost of borrowing goes up, those who rely on debt to function end up struggling to keep their heads above water. But what happens when a whole nation relies on ever-increasing levels of borrowing and debt to operate?

Australia may be about to find out.

Financial conditions are certainly “tightening,” says Australian bank abn amro chief economist Kieran Davies. Official and unofficial interest rates are rising, and lax lending standards are being toughened. Others are a little more pragmatic. “We are in the process of bringing the curtain down on what has been a super cycle for the Western world’s financial institutions, which was built on the willingness of consumers to increase their leverage [debt] at fantastic prices,” says investment bank Morgan Stanley’s chief economist Gerard Minack.

“The escalation in leverage over the past 20 years is completely off the scale. It is bigger than the 1890s property boom and bigger than the 1920s. It is bigger than anything we’ve ever seen, and I think we’ve reached the limit of how far these trends can go. The unraveling will be extremely painful.”

Why are financial conditions tightening? Just as in America, Australians have spent too much, and their debt is backed by grossly inflated assets. The difference is that the Aussie crisis could be much worse.

Australians may be the most indebted people in the world.

As ludicrous as it sounds, according to the Australian, Australians have been compounding their debt at an average rate of 15 percent for the past 20 years. In 1988, the average household had debts totaling 32 percent of its income. Now the average is a massive 160 percent of household income. As a percent of gross domestic product, household debt has reached 177 percent, almost a world record. Meanwhile, wages have grown at less than a third that rate.

Even with the recent tightening—which included the lowest level of bank lending in 25 years in June—Aussie households have $95 billion more debt now than they did a year ago. That equates to an additional $4,611 of new debt on average for each man woman and child in the country—in just one year.

“It’s like a debt tsunami out there,” says Sandra Saker, who manages a Salvation Army Service for families in Sydney suffering financial problems. “Five years ago, the maximum debt people came in with was about A$200,000. Now we see people coming in with over A$1 million.” But all this shouldn’t be too surprising for Australians. Home prices have been going through the roof.

Housing Bubble: Soft Underbelly of the Economy

Australian homes are arguably the most expensive in the world by some measures—no small achievement considering the massive run-up in home prices in the U.S., the UK and elsewhere. Since 1999, the median house price has soared an amazing 140 percent.

Several indicators show how extreme home prices have become. The house price to average income ratio in Australia is approximately 6. That means that Australians on average are paying more than twice as much for homes as Americans were before their housing bubble burst (in the U.S., the ratio peaked at about 3). The Washington-based International Monetary Fund says Australian house prices are overvalued by almost 25 percent when compared with the homeowner’s ability to pay the mortgage.

Assessed as an investment, Australian houses are also very pricey. On average, rents earn about 3 percent, versus the standard mortgage rate of 9 percent—which means that if the house prices do not appreciate, investors go in the hole about 6 percent a year.

“By every metric I can think of, Australian houses are too expensive,” confirms Gerard Minack. He is predicting that prices will fall by 30 percent over the next two years.

If Minack is correct, and home prices are not sustainable, the economy could be in for a big shock. Rising property prices was the catalyst that encouraged consumers to increase spending and keep Australia’s economy expanding despite the “Asian Flu” in the late 1990s and dotcom bust in the 2000s. And the housing and related industries are what is largely powering the economy today.

Approaching Tsunami

Unfortunately, it is increasingly evident that Australia will not escape the housing bubble meltdown plaguing the Anglo-sphere’s two largest economies, the United States and the United Kingdom. The same factors that popped these economies—rising default rates, rising borrowing costs, and slowing economic growth—are in play in the island nation.

The wave is already breaking. House prices in every major city in Australia fell last month—the first time such an event has occurred since just before the Great Depression. Sydney, Melbourne, Brisbane, Perth, Adelaide, Darwin, Hobart, Canberra—all the big boys went down.

“I panicked” upon seeing the data, said John Edwards, chief executive of Residex Ltd., a company that tracks property prices. “We’ve been doing this for 20 years and have data that goes as far back as 1865, and it’s really abnormal.”

“Australia is headed for a once-in-100-year real-estate slump,” he says. “I have never seen the convergence of so many negatives.”

And when the housing market goes, the economy will really feel it.

At first it will be real-estate agents and loan brokers that lose their jobs as sales slow. Construction workers will soon follow, as property developers find that new homes are not selling either. Next it will be the employees at home improvement stores like Bunnings and others.

But that is only the beginning. Once the average home owner on the street finds out that his house is worth only three quarters or half of what it was last year, then things will really start to deteriorate.

People are not so free with their money when they think they are poor, and especially when they think they are going to get poorer. In fact, they do the opposite: They begin to squirrel money away. Once consumer spending begins to contract, then the housing contagion will spread into the general economy. People won’t be spending on flat screens, cars and vacations. Business profitability will fall, and then the job losses will really get under way. Those already announced by Qantas and Starbucks are a harbinger of many more to come.

The resource boom won’t save the economy either. As a percentage of gdp, the mining and related resource industries originate approximately 8 percent of the total economy. Consumer and government spending account for 74.6 percent of Australia’s economic activity (as of 2006) and absolutely dwarf the real wealth-producing parts of the economy.

“It is amazing that in the midst of the biggest commodity boom ever seen [Australia has] still been unable to get a current account surplus,” says Gabriel Stein from Lombard Street Research. “They have been living beyond their means for 10 years.” Even houses in resource-rich Western Australia are falling in value.

And don’t forget what a collapsing housing bubble could do to Australia’s biggest banks.

Sydney research company Fujitsu Consulting estimates that 923,000 households will face “mortgage stress” by September. That is up from last year’s survey that found only 171,000 that were having trouble repaying loans. Since there are 6.9 million Australian households with mortgages, an astounding 13 percent of the total market could be in serious trouble. Any guesses what those kinds of default rates could do to Australia’s leading banks? They could quickly resemble the Bear Stearns and Northern Rocks of America and Britain. The share prices of Australia’s biggest banks are already plummeting.

Surf’s up: A massive wave of debt-induced economic problems is about to break on Australian shores. And Australia is about to pay the consequences of years of too much “easy money.” As investment bank bnp Paribas currency chief Hans Redeker says, referring to Australia’s currency: “The Aussie is going down, big time.” readers are warned to head for high ground. Australia is in the same position that America was in about a year and a half ago—just before its housing problems set off the global credit crunch that has since rippled through the global economy. Begin by reading “Ending Your Financial Worries” and Australia—Where to Now?

I'm not agreeing with everything in this article but it is hard to disagree with a lot of the broad trends that have been outlined. Australians are up to their eyeballs in debt, that is clear.

The idea that Australia is different because we have a lot of rocks in the ground that asia needs is simply nonsense. We have particpated along with the rest of the world in the massive expansion of credit that has driven up house prices to ridiculous levels and we will most defintely particpate on the way down.

Monday, 25 August 2008

Still Not Time to Buy Aussie Banks

Back in February I posed the question; Time to Buy the Big Four? At that time I noted that:

...considering the pummeling their counterparts in the US and in some parts of Europe have taken, the share prices of Australian banks have held up relatively well. That's mainly because their profits have held up well and they have steered clear of the sub-prime meltdown....for now.

'For now' is the important part. As we move further into the sour end of the credit cycle we can expect profits to slow and bad debts to rise.

As we now know, ANZ and NAB weren't able to avoid some the problems of their overseas counterparts. CBA and WBC have been able to far. Whilst CBA and WBC have avoided subprime related problems, as predicted they have had to raise their doubtful debt provisions significantly and as noted last week, impaired assets are now rising sharply.

6 months ago I predicted that investors would get opportunites to pick up bank stocks at more attractive prices down the road. Since then all 4 major banks stocks have moved lower, ANZ and NAB considerably so.

I see no reason to change that view. 6 months ago signs were beginning to appear that the Australian economy was slowing - following the US and European lead. Those signs have now been confirmed and in such an environment coupled with continued strains in credit markets, banks will continue to do it tough.

Friday, 22 August 2008

Quote of the Day

Warren Buffet has come up with some great quotes over the years. On CNBC Friday morning he built on an earlier quote to come up with an absolute pearler.

"I think I said one time that you only find out who's been swimming naked when the tide goes out, well we've found out that Wall Street has been kind of a nudist beach."

Click here for the interview

Thursday, 21 August 2008

Deflation is Here

Back in December I posed the question; Inflation or Deflation? Since then I have maintained that deflation will become the more dominant in 2008.

Yes but what about the rampant price inflation we have seen over the last 12 months, in particular food and energy? Firstly any discussion of inflation and deflation should define what they actually are. Here's what I wrote back in December:

Firstly what is deflation? Typically it is a decrease in the money supply or amount of credit in the system and a decrease in the demand for goods related to the inability to access credit. Sounds like the opposite of inflation doesn't it? Funny that.

OK so what exactly has been happening to the money supply? An interesting article in the UK Telegraph surfaced on Tuesday addressing this very topic.

Sharp US money supply contraction points to Wall Street crunch ahead
The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.

Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959.

"Monthly data for July show that the broad money growth has almost collapsed," said Gabriel Stein, the group's leading monetary economist.

On a three-month basis, the M3 growth rate has fallen from almost 19pc earlier this year to just 2.1pc (annualised) for the period from May to July. This is below the rate of inflation, implying a shrinkage in real terms.

The growth in bank loans has turned negative to a halt since March.

"It's obviously worrying. People either can't borrow, or don't want to borrow even if they can," said Mr Stein.

Monetarists say it is the sharpness of the drop that is most disturbing, rather than the absolute level. Moves of this speed are extremely rare.

The overall debt burden in the US economy is currently at record levels, raising concerns that a recession - if it occurs - could set off a sharp downward spiral.

Click on the link above for the full story. A contracting money supply and deflating home and stock prices, looks like deflation is well and truly here. Yes but how about price inflation? I think Kevin Depew of Minyanville summed it up well on Tuesday:
the obsessive focus on inflation is like a weird obsessive focus on the sun setting in your rear view mirror while you drive straight over a cliff.

Wednesday, 20 August 2008

Impaired Assets of Aussie Banks Start to Climb

I first posted this graph back in February. Since then, impaired assets have increased sharply. The more important line in the graph is the "impaired assets as a percentage of total assets." It has also turned up sharply but is still very low by historical standards.

If we consider that the impaired assets ratio peaked at 0.69% in 2002 and that it was fairly mild as far as credit cycles go, we can probably expect that ratio to climb well above that level this time around given the explosion in credit in the intervening period and the great unwind now underway.

It should be noted as well that the graph above only includes data until the end of March 2008, before any of the announcements by NAB and ANZ. Also the Australian economy really only started to show clear signs of slowing after March.

As the economy slows further and unemployment rises into 2009 putting further pressure on households, impaired assets will rise in the household as well as the corporate sector. Whilst the RBA may decide to cut interest rates aggressively in such an environment, there is much doubt surrounding the ability of banks to pass those cuts on to customers as they contend with higher funding costs.

Tuesday, 19 August 2008

No Bottom For US Housing No Surprise

It's been a while since I posted on US Housing. However there were no surprises unless of course you were expecting a bottom anytime soon. Here are the details in brief:

Permits were down -17.7% from June to a SA annual rate of 937,000 and were -32.4% below July 2007. Permits for single family homes fell -5.2% from June to a SA annual rate of 584,000 and were down -41.4% from July 2007. The lowest level since August 1982.

Starts were down -11.0% from June to a SA annual rate of 965,000 and were -29.6% below July 2007. The lowest level in 17 years.

Completions were down -8.7% from June to 1,035,000 and were -31.7% below July 2007. Completions of single-family homes dropped -7.2% in July to a SA annual rate of 791,000, the lowest since March 1983.

Remember permits are generally considered a better indicator of building fundamentals than starts, which can be heavily influenced by weather conditions. The sampling error on permits is also lower.

Completions follow starts by about 6 months. The decline in permits in July suggests further drops in starts next month. It will be interesting to see if the bottom callers start making noises today, I'm betting they will be conspicuous by their absence.

Parsing the RBA

The RBA released the minutes of their August 5th meeting today. Below are some of the pertinent points:

Members considered the information provided by the regular monthly data releases, covering household consumption, the housing and business sectors, the labour market, and trade and commodity prices.

They observed that consumption spending had weakened considerably in 2008, with retail sales being essentially flat in value terms over the first half of the year. In volume terms, retail spending had fallen in this period, with both large and small retailers exhibiting weaker trends in sales.

The phrase weakened considerably was noteworthy as previously the RBA had only alluded to a "slowing" in consumer spending.

Given there had been a significant change in borrowing behaviour, confidence was weaker, asset prices had declined and slower overall growth was in prospect, tighter financial conditions were not warranted. Indeed, less restrictive conditions could soon be called for, otherwise the risk of a deeper and more persistent slowing in the economy would increase. On these considerations, a case could be made for an early reduction in the cash rate.

Weighing up all these considerations, members judged that the current stance of policy was appropriate for the time being. Nonetheless, given the slower trend in demand, scope to move towards a less restrictive setting of monetary policy was judged to be increasing.

That the RBA has moved to an easing bias is not news but whether they begin cutting next month or at some later date is unclear. Also unclear is whether the major banks will follow the RBA cuts.

I have a feeling that the banks will at least follow the first few moves by the RBA, however if the RBA cuts aggressively over the next 12 months, tight credit market conditions will make it all but impossible for the banks to follow.

Sunday, 17 August 2008

Analysts Still Playing Catch-up on Earnings

A theme that I have been harping on for the best part of a year is earnings. Earnings cycles never last much more than about 5 years. However, analysts being the optimistic bunch they are, often project 10 or more years of steady earnings growth into their models.

Thus they never anticipate turning points in the earnings cycle and are constantly playing catch up all the way down. I've laid the evidence out for this many times. About 6 weeks ago in Analyst Earnings Forecasts Still Too Optimistic I commented that analysts forecasts for US 2Q08 operating earnings growth of -9.2% would end up being twice as bad when the earnings season was done. It appears I was being overly optimisitic.

Now with 88% of S&P500 companies having reported earnings, as seen below 2Q08 earnings slumped -29.3% year over year. Once again the analysts have been caught short and have forced to chase the numbers down.

But thankfully we can put this ugliness behind us. Next quarter is the first year over year earnings season since the credit crunch started and therefore the comparisons will be much easier. That is reflected in the analysts forecasts predicting 6.3% operating earnings growth in 3Q08.

Are these numbers justified? If you've been paying attention you should at least be a little skeptical. Are these forecasts simply a result of easier comps? Certainly some of it is but definitely not all. As you can see below, looking at the actual earnings numbers, analysts are expecting a significant improvement in 3Q08 compared to the previous 3 quarters.

What is the source of optimism that will see 3Q08 earnings significantly higher than the previous 3 quarters? Drilling down sector by sector we find the following below.

Financials are expected to turn around from a negative number to a positive. How the fortunes of financials are expected to turn around in the next quarter escapes me. Energy is expected to explode higher, an interesting call in light of what oil has been doing over the past month. Lastly consumer discretionary is poised to rebound. A big call in light of the fact that the rebate checks could not prevent 2Q08 earnings growth being the worst in some time.

Back in May in 1Q08 S&P500 Earnings Continue To Tumble I stated that the then positive forecast earnings growth for FY08 was "wildly optimistic." As can be seen below, analysts have finally come around to that reality with FY08 earnings expected to be down -2.1%. However that will also prove to be optimistic and will more likely show a double digit decline when all is said and done.

The last chart below is one that regular readers will be familiar with. Put simply it aims to show how long it took for earnings to recapture their former highs after previous earnings cycle peaks.

After the peak in June 1989 earnings did not hit new records until June 1994 - a full 5 years or 20 quarters later. Earnings then peaked again in June 2000 and didn't recover to the previous peak until December 2003, a full 3 and half years or 14 quarters later. Currently analysts would have us believe that the earnings peak in June 2007 will be surpassed in 4Q08, just 1 and a half years or 6 quarters later.

Once again the optimism of an early earnings turnaround is unwarranted. What started out as a credit event effecting financials has now spread to the wider economy and therefore the earnings of non-financial companies.

One last word on US operating earnings. Operating earnings are basically earnings before bad stuff, that means before all the financial companies writedowns. It also means before charges taken at GM and Starbucks. If those were included things would look much worse.

Wednesday, 13 August 2008

Repeat After Me: This is Not a One Year Event

Regular readers, (do I have any of those?) may recall a post I made back in October of last year titled; Repeat After Me: This is Not a One Quarter Event. At that time, writedowns by financial institutions were seen as one-off, short term interruptions to business as usual.

My suggestion was at the time that it would take much longer to play out, and here we are in the midst of 3Q08 and we have more evidence that things continue to deteriorate and hence the title of today's post.

On Tuesday JP Morgan visited the SEC confessional revealing that it took a $1.5 billion write-off on mortgage-backed securities and loans. The company commented that;

"Trading conditions have substantially deteriorated versus the second quarter,"

Also owning up to more pain was UBS which recorded its fourth straight quarterly loss on sub-prime related writedowns. The company said in a statement that;
UBS does not expect to see any improvement in the adverse economic and financial market trends'' in the second half of the year, the bank said, adding that it will continue to reduce staffing, costs and risky assets.

So now that you know this is not a one quarter event, but I'm here to tell you this is not one year event either, it will be several. The important point for stockmarket investors is, when will all this be priced into the stockmarket? Of course noone knows the answer to that, however I think it's safe to say, not yet.

Tuesday, 12 August 2008

Lower Oil & Interest Rates No Market Panacea

The bottom is in for the stockmarket, didn't you know? Oil has shed more than 20% in the last month. Add to that the RBA now has an easing bias and you have a powerful catalyst for stocks. If only it were that easy.

As is my penchant, I will take the opposite side of this trade, not for the sake of being a contrarian but because there is plenty of evidence to suggest the stockmarket is far from a bottom.

Firstly why is oil falling? Is it those damn speculators? Funny how we don't blame the speculators when oil drops, apparently it's demand destruction, now if it is demand destruction, what does that tell you about the health of the global economy? This is what it tells Marc Faber:

Investors speak of weak oil price as being bullish but the point is that it signals the global economy is in recession already.

I absolutely concur. Is the global economy really headed for recession? Rather than me try to answer it I will let Nouriel Roubini explain :

Let's detail why we a global recession is now likely...This global recession is being fed by a variety of factors: the bursting of housing bubbles in many economies (US, UK, Spain, Ireland and other. Eurozone memebers); the burst of massive credit bubbles in countries where money and credit used to be too easy for too long and supervision and regulation of credit too loose; the severe credit and liquidity crunch following the US morgage and debt crisis; the most severe financial crisis since the Great Depression (not as bad as the Great Depression but second only to that episode); the negative wealth and investment effects of falling stock markets (that have already fallen globally by a bearish 20% plus); the burden of high oil and commodity prices for commodity importing economies; the global effects via trade links of the US recession (as the US still counts for about 30% of global GDP); the weakness of the US dollar that is reducing the competitiveness of countries exporting a lot to the US; the stagflationary effects of high oil and commodity prices forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and to financial stability.

In the US data suggest that the economy entered into a recession in the first quarter of this year as the five indicators used to define a recession (GDP, employment, production, income and sales) all peaked and then contracted between October 2007 and February 2008. The economy rebounded - in a double-dip W-shaped recession - in the second quarter boosted by the temporary effects on consumption of $100 billion of tax rebates. But those effects will fade out by late summer while the more persistent factors hitting a shopped-out, saving-less and debt-burdened US consumer will remain: falling home values; falling stock prices; credit crunch in mortgages and consumer debt (credit cards, auto loans, student loans) ; rising debt and debt servicing ratios as mortgages and other consumer debt interest rates are resetting higher; high gasoline and food prices; collapsing consumer confidence; and, most important, a fall in employment for seven months in a row.

Similar factors are at play in the UK, Spain and Ireland where housing bubbles are going bust together with a bust of excessive consumer debt thus leading to a recession. But even in Italy, France, Greece, Portugal, Iceland and the Baltic economies frothy housing markets are starting to deflate. More broadly and ominously all of the Eurozone is now headed towards a recession including the three largest economies and G7 members: Germany, France and Italy. Bursting of housing bubbles; the effects of the liquidity and credit crunch that has also hit European financial markets and limits the ability of European firms to borrow, hire and invest; the fall of exports to the slumping US; high oil and commodity prices; the loss of competitiveness of Eurozone exports with a super-strong Euro; and the hawkishness of the ECB that - unlike the US Fed that aggressively cut policy rates - first kept rates on hold and has recently raised them to fight inflation. So no wonder that production, sales and consumer and business confidence are all falling in the entire Eurozone. And thus second quarter Eurozone GDP growth will be even worse - and close to zero - than the US while the future growth ahead looks even worse.
Of the remaining G7 economie Japan is already contracting. Japan used to grow modestly for two reasons: strong exports to the US and a weak yen. Now the exports to the US are falling while the yen is not as weak as before. On top of these two negative shocks two other shocks are pushing Japan into a recession: high oil prices for a country that imports all of the oil that it consumes; and falling business profitability and confidence.

The last of the G7 economies, Canada, should have benefited from high energy and commodity prices; but its GDP has already contracted in the first quarter. With a quarter of its GDP exported to the US and such exports being three quarters of its exports Canada's economy is totally dependent on a sick US economy that is contracting.

So literally every single G7 economy is now headed towards a recessionary hard landing. And now other smaller economies (mostly the new members of the EU that all have large current account deficits) are at the risk of a sudden stop of capital and reversal of capital inflows that could trigger a hard landing; such hard landing is already occurring in Latvia, Estonia, Iceland and New Zealand. This G7 recession will next lead to a sharp growth slowdown in emerging market economies and likely tip the overall global economy into a recession.

But how about Australia? At least we have the luxury of relative high interest rates to begin cutting from. However, just as interest rate cuts failed to stop the US from sliding into recession and stockmarkets from falling, so it will be down under.

Today's NAB business survey suggest business conditions are deteriorating shaply to levels not seen since 2001 whilst business confidence is at levels not seen since the last Australian recession.

Also, the RBA is now starting to sound worried:

Now the Reserve says it's worried
AUSTRALIA's Reserve Bank has expressed deep concern about Australia's economic outlook, presenting forecasts that suggest it might have lifted interest rates too high.

The RBA's latest quarterly statement predicts that economic growth is about to slow and that unemployment will climb to 6%.

The Reserve Bank warns that, while these are its central forecasts, and headline inflation is now expected to peak at 5% in December, any further deterioration in the global outlook could lead to a "significant deterioration" beyond those forecasts.

The RBA predicts that Australia's annual rate of jobs growth, at present 2.3%, will slow to three-quarters of 1% almost straight away. The forecast implies a jump in unemployment from 4.3% to 6% by the end of next year.

Australia's rate of economic growth, at present 3.6%, is forecast to slow to 2% by the end of this year, with about half of that coming from the mining and agricultural sectors, implying a paltry 1% growth rate in the rest of the economy.
But don't worry;

A member of the Reserve Bank board, former Woolworths chief Roger Corbett, told Sky News yesterday that Australia was "resilient" and had a strong, broad base.

Haha, where have we heard that one before?

In the US, despite the government's best attempts, the worst of the credit crunch is not over. Atl-A is the new subprime only it is much worse. There will be waves of mortgage resets in coming months and well into 2009-10. Also, right on cue, C&I loans are starting to deteriorate.

All this adds up to sharply higher delinquincies more bank writeoffs, dvividend cuts, capital raising and bankruptcies to look forward to over the next 12 - 24 months.

Now that the evidence is in, Martin Feldstein, former head of the NBER, (the organization that calls recessions) estimates that less than 20% of the rebate checks mailed out to the ailing US consumer were spent, confirming that such stimulus methods are next to useless.

All this hasn't stopped the cheerleaders from calling a bottom in the US housing and stock markets. Remember that these are the same geniuses who did not see a recession coming, did not see a bear market in stocks and were calling for a second half rebound in the US economy. A rebound, as predicted here, that has now been cancelled.

And don't fall for the crap that the stockmarket is currently undervalued. This weekend's financial Review devoted two pages to so-called experts who claim the market is cheap based on forward earnings.

As soon as you hear forward earnings you can usually stop reading. The US market looked cheap in November last year when analysts were predicting double digit earnings growth for 4Q07, 1Q08 and 2Q08. As we now know 4Q07 earnings plunged more than -30%, 1Q08 was down more than -25% and 2Q08 is now down about -23% with more reports yet to come.

Of course that doesn't mean we won't see the trademark bear market rallies of the short and sharp kind. Just don't get sucked into thinking the worst is behind us just yet or that more importantly, the stockmarket has discounted it.

Saturday, 9 August 2008

My Portfolio Year 2, 9 month return

Unless you've been living under a rock you would know that good returns in the stockmarket have beeen scarce this year and my portfolio has been no exception. Over the last 9 months, my portfolio is down -3.8% and that result was helped along by a well timed trade back in January.

That said, compared to the XAO, my portfolio has held up fairly well as the XAO is down -23.3% over the same period.

I sometimes get asked and almost chastised as to why I don't short stocks if I think the market is going down. My answer is usually, why should I? As a long term investor my aim is to outperform the market over the full market cycle. Sometimes that may imply long periods of doing absolutely nothing and over the last 12 months that strategy has paid off.

I don't deny that poeple can profitably trade stocks both up and down on a short term basis, good luck to them if they can. However I think there is a mentality, call it a traders mentality, that you need to be constantly doing something. That can be very harmful, particularly if you feel the need to do something when you don't know what you're doing.

Thursday, 7 August 2008

Aussie Employment Shows Resilience in July

Despite a recent slew of economic data showing a weakening Australian economy, the Australian labour market continues to show resilience. According to a report released by the abs today, 11,000 new jobs were added in the month of July whilst the unemployment remained at 4.3%.

Employment is a lagging indicator and we shouldn't be too surprised that the economy is still adding jobs. Firms typically don't lay off employees until they absolutely have to.

That said, with a reduction in the number of job advertisements and the employment components of the PMI, PSI and PCI all now showing contraction, don't be surprised to see the unemployment rate to start and tick up before the end of the year.

Wednesday, 6 August 2008

Oz Housing Credit Continues to Contract

Data released today showed that credit growth for owner occupied housing continues to contract, the number of loans for owner occupied homes excluding refinancings fell a seasonally adjusted -4.9% in June and represents the fifth straight month of falls. On a year over year basis they are now down -30% to levels not seen since October 2001. Whilst the total value of owner occupied home loans is down -29% year over year.

A slowdown in the Australian economy is in doubt now, the question is shifted to the severity of the slowdown. In the space of a week we have had two reports showing that both the Australian Manufacturing and Services sectors contracting for the second straight month. Today, the Performance of Services Index report for July showed that the Construction industry has been contracting for 4 straight months.

The graph above shows a sharp slowdown in construction activity and coupled with a contracting services and manufacturing sector, sluggish retail sales, contracting credit and falling business and consumer confidence, the Australian economy appears to be slowing sharply.

I would expect in the coming months that we will start to see employment losses and the unemployment rate start to tick upwards. Whilst the US has experienced somewhat of a slow-motion slowdown, Australia's slowdown appears to be happening more rapidly. The Australian Treasurer may say that talk of recession is silly at this point, but that talk will only get louder in the months ahead.

Tuesday, 5 August 2008

Get Ready For Rate Cuts

Back in mid-June I posed the question, Is the RBA Done? Today I think we got an answer. Whilst the RBA left the cash rate unchanged at 7.25%, the accompanying statement gave a hint of what was to come. Here is the money quote:

Weighing up the available domestic and international information, the Board judged that the cash rate should remain unchanged this month. Nonetheless, with demand slowing, the Board’s view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing.

As can seen below the cash rate futures market got very excited. They are now pricing in 50 bps of rate cuts by November. Back in June they were pricing in another 25 bp rise.

The markets could be jumping the gun, the RBA may take its time to cut but the direction of the next move is no longer in question, we are now entering an interest rate cutting cycle.

Just how far will the RBA go? I believe they will go much further than most expect. The problem is that a significant amount of damage to the Australian economy has already been done and just as we saw in the US, slashing interest rates will not stop a significant slowdown in the economy.

Take the Performance of Services Index (PSI) released today. Like the PMI reported last week, the Australian services sector saw its second straight month of contraction in July and was the worst result in the series since it was started back in February 2003. Of particular note the Employment component plunged 6 points to 42.2, well below the 50 mark that differentiates expansion from contraction.

Numbers like this coupled with other recent data showing sluggish spending numbers and a sharp slowdown in credit growth point to a rapidly slowing Australian economy.

Of course, rate cuts are generally good news for the stockmarket however I believe we will see that same course of events that played out in US. The markets rallied after each rate cut only to move lower as the market came to grips with the reality of a deteriorating economy and the knock effects to corporate profits.

Monday, 4 August 2008

There Should be No Surprises

There should be no surprises about the recent writedowns, profit warnings and rising bad debts from Australian financial institutions. For those paying attention to events in both the U.S and Europe it was really only a matter of time until Australian financial companies started to own up to problems of their own.

However, Australian financials, particularly the major banks, have weathered the storm relatively better than their US and European counterparts. Have our financial institutions been more prudent and better managed? Or are we just playing catch-up?

If the U.S was the starting point for the current problems we inhabit it may be instructive to look there for some answers to the questions posed above. Over the past 12 months we have seen roughly the following sequence of events.

  • A flat out denial of any problems by major financial institutions.
  • Then an admission of some problems, writedowns were taken, assurances that dividends would not be cut and that balance sheets were adequately capitalised
  • Then more writedowns, CEO's sacked, rising bad debts, dividend cuts, job losses and capital raising but assurances that further capital raisings would not be necessary.
  • Then surprise surprise, more writedons, more dividend cuts and in some cases completely eliminated, further capital raisings, asset sales, government bailouts and bankruptices.

Of course, the above sequence hasn't been the same for all financials, some have moved through various stages at different times, some skipped over some stages whilst others will never enter some stages (e.g bankruptcy). However, investors by now should have picked up on some general themes. Companies won't announce bad news until they absolutely have to and assurances from management that everything will be fine, cannot be believed.

What have we seen to date in Australia? Rising provisions for bad debts from major banks, writedowns from NAB and provisions for CDS exposure from ANZ. Profit warnings from both companies, just last week SUN announced a tripling of bad debts and a significant fall in earnings whilst NAB's CEO was forced to walk away from the top job along with plenty of assurances that things will be OK.

So does that mean we can expect dividend cuts, capital raisings, bankruptices and government bailouts in the coming months for Australian financial institutions? Not necessarily but it pays to be cognizant of what we have seen overseas in the past 12 months and as investors, plot a course of action accordingly.

Remember that during the rollercoaster ride of the last 12 months analysts have continually been calling for a bottom in financial company stock prices only to see them put in new lows each time.

Rather than ask, is it time to buy Australian financial companies? A better question might be, Given the relatively small amount of bad news from Australian financial companies, what is the likelihood that all the bad news is out there and that stock prices have fully relected it?

Friday, 1 August 2008

No Joy in July

As predicted July turned out to be another downer for the XAO, the index dropping -5.3%. That makes seven monthly declines in the last nine months.

Last month I said that contrary to popular opinion, the sharemarket had not made a bottom and would continue to head lower which it subsequently did. I see no reason to change that view.

There are growing signs that not only is the Australian economy slowing but it is slowing more rapidly than the RBA and most other pundits thought. Data released today showed that the PMI fell again in July showing a contraction in the Australian manufacturing sector for the second month in a row.

Retail Sales for June were flat and the SFE cash rate futures is now factoring in a rate cut by the end of the year. Financial sector problems continue and in my estimation are only just kicking into gear in Australia. Expect more writedowns from major banks, rising levels of bad debts and increased funding costs to impact earnings and ultimately stock prices.

So I have no doubts that the stockmarket is headed lower over the medium term as it begins to discount the possibility of the first Australia recession in almost two decades a declining profits outlook (anyone notice SUN today?)and a worsening global economic outlook.

With respect to August, history suggests that August is a reasonable month for stocks, having risen 15 times in the last 23 years. As usual though that is no indication of what the market will do this August.

The latest bear market rally was snuffed out rather quickly, I had expected it to last a little longer. No doubt there will be more rallies to come during the current bear market however I don't think it will be enough to put the XAO in positive territory for the month of August.

* Don't forget to vote in this months poll at the top left of the blog.