Delusion is a powerful thing

The All Ords rebounded almost 2% today clawing back most of yesterday's losses. Today's rally had conviction, strong volumes as buyers were back with a vengeance. The sentiment seems to be that the recent sell-off triggered by the Shanghai markets last week was just a short correction and the time is ripe to jump back in and pick up some bargains.

However there seems to be a disconnect in thinking with the US. US investors have strong memories of a recession just a few years ago which Australia bypassed riding the back of the resources boom and a generally strong economy. Also today the $USD fell below 116 to the yen. Anecdotal data suggests money is flowing out of Mutual Funds at a rapid rate. Sentiment in the US seems to be that they are getting prepared for a bear market. The US economy is looking shaky, durable goods orders well down, new home sales and new house prices down in January. Inflation risk to the upside and credit market troubles gaining momentum.

Australia's economy is looking weaker now than it has in the past few years. Official GDP growth numbers due out soon will show a sluggish expansion of around 2%. The commodities boom has run, any increases in prices if at all will be moderate going forward. Inflation is still slightly ahead of where the RBA would like it and the risk to interest rates is leaning toward a hike.

Australian investors haven't seen a bear market for 6 years. The stockmarket tends to have a short memory of such things. The economy is not in such good shape to ignore the US lead. A 5-6% correction in stock prices does not mean value has been restored. Equity market valuations have gotten so far away from reality in recent years as to be bordering on the ridiculous in some sectors. I'll be holding on to my yen for a little longer. The best bargains are yet to surface.

You Can't Have Your Cake & Eat It Too

This article puts in persepctive the fantasy of the goldilocks economy or 'soft landing' scernario. The soft landing argument goes something like this, raise interest rates to slow the economy and keep inflation in check but not too far to push the economy into receession. Key to this scenario playing out is that housing doesn't fall off a cliff- and so far it hasn't however signs are looming that it might just be a matter of time. As the article suggests delinquencies and foreclosures are on the rise, banks are applying stricter lending policies whilst upping their provisions for doubtful debts.

Durable Goods orders fell almost 8% in January, maybe its a little early to tell if this is a knock on effect from the housing sector but it certainly can't be ignored. 4Q06 GDP growth was revised down to 2.2% whilst inflation in January has not subsided and actually core inflation showed its highest rate of growth in seven months outside of the Fed's preferred range of 1 - 2%.

As the article suggests if the Fed tries to reign in growth in the money supply to tame inflation short term interest rates will rise putting further pressure on housing. If they do nothing the Fed looks like they are dropping the ball on inflation. The Goldilocks economy could easily transform into the 3 bears economy. The 3 bears being a collapse in housing, slowing growth and rising inflation. Just the right envirnoment for the equities bear to come out of hibernation.

I still can't hear you, show me the money!

That's right I'm still picking on CYN. Not because they are doing anything terribly wrong - I could have picked any one from dozens of small companies. More to the point I wanted to contrast them with another small company ANH.

Firstly CYN's 1H07 results. Management seems to have run out of pep in their commentary and for good reason. Revenue up just 8% on pcp, loss after tax reduced by just 6% from -$3.5m to -$3.3m. Looking at the numbers a slight improvement on the previous year but no indication that they can run a business profitably and no indication from management that they will be able to any time in the near future. It's business as usual over at Cygenics.

ANH is an online media company that derives revenue from selling advertising space on a network of search engines, portals and popular websites. Briefly ANH's 1H07 results Revenue up 105% Net Loss up 59% from -$0.67m to -$1.05m. To be fair the increased loss included $0.52m in share-based payment expenses. Revenue growth is good but they are yet to turn profitable. ANH also stated 5 objectives they wish to achieve for the rest of the FY07, one of them being..

"Achieve month on month profitability"

Also CEO Dean Jones commented in an interview on boardroom radio late last year that the biggest challenge going forward was to manage the strong revenue growth by controlling costs. Whether they can achieve month on month profitability remains to be seen but at least management are communicating to the market that operating a profitable enterprise is at the forefront of their minds - as it should be.

Freddie Mac - we'll only buy almost anything

By now I'm sure you've read a hundred articles about the the Shanghai panic that led to a world-wide sell off of equities so I'm not going to add to the pile. My friend over at Shenandoah Capital has a good article that summarises what led to the carnage of the last 24 hours. More specifically I think what happened in Shanghai and the reverberations it caused are a sideshow to the main event yet to unfold.

MarketWatch.com carried an interesting article today on Freddie Mac getting tough on subprime mortagage standards. Freddie Mac shouldn't be confused with a bank or other financial institution that lend to potential homeowners. They actually buy mortgages and then sell bonds and other securites backed by those mortgages. You may know this process as securitization. They make money off the differential between the bond rate and the purchased loan, e.g. they buy a loan with a 5.25% interest rate put it in a mortgage backed security with a coupon of 5% effectively pocketing the 0.25% differential. OK, so what does Freddie Mac mean when they say they are getting tough on subprime mortgage standards?

Firstly what is a subprime mortgage? Basically its a high risk loan. Subprime mortgages are aimed at those who don't qualify for loans at mainstream financial institutions, although increasingly subprime lenders are just affiliates of mainstream lenders operating under different names. Generally they operate the same as prime mortgages but only with a higher interest rate to compensate for the higher risk.

Now that's great for those who have a hard time demonstrating to a bank they have the requisite amount of assets such as those whose livelihood is cash based or who run their own business. However think of the logic behind it for a minute. Someone who couldn't qualify for a loan at a mainstream institution because they are deemed too high a risk qualify at the institution's affiliate at an even higer rate and therefore even higher risk.

In the article Freddie Mac said they will:

"limit the use of loans that don't require income verification or other documentation."

So basically you can get a loan without having to verify your income level or assets, what the f...? Freddie Mac has been purchasing and selling loans that don't require proof that the borrower can pay them back and remember they are not going to stop doing this they are just going to limit them to those customers that are fully underwritten at the full borrowing rate not a discounted 'teaser' rate. That doesn't guarantee that the customer won't default it just excludes the riskiest customers. Further on in the article..

"In addition, the company won't purchase "no income, no asset" documentation loans and will limit so-called "stated income, stated assets"

What this all means is that Freddie Mac has gone from buying anything to almost anything. Senator Christopher Dodd of the Senate Banking Committee labelled Freddie Mac's move as:

"a responsible standard that ensures that these borrowers will have the ability to repay their loans, thereby protecting their home equity," "This is the right thing to do both for the borrowers and for Freddie Mac."

I think the senator is overstating it a little, I'm not so convinced.

Sure Freddie Mac is making an effort but look at what we're talking about here. Lenders have become that greedy they will lend to people who they don't even know can pay back the loan. So what, that's the environment of easy credit we live in these days you might say. Well I'd say something is wrong. Below is one of my favourite charts of late posted here without permisson from the Contrary Investor Read the whole article in the link above and tell me if you think everything looks rosy on the US home ownership front.

All Ords 7000 here we come!

Anyone for a little irrational exuberance?
As the All Ords breached the 6000 mark for the first time last Friday euphoric cries of All Ords 7000 by the end of year have rung out. That would imply another 16.7% rise in the benchmark index in about 10 months. This in a year when corporate profits are forecast to slow bad debts are on the rise and housing is still sluggish. Sounds likes a recipe for a nasty correction. Yes most economists are now tipping no interest rate rises for the rest of the year although the RBA retains a tightening bias.

The received wisdom has it that no rate rises or the chance of rate cuts is good news for stocks. I always thought this was a counter intuitve argument since central banks usually lower interest rates in order to stimulate growth. If economic growth is contracting and by implication corporate profit growth slowing which way do you think stock prices should be heading? Of course we are not into an interest rate cut environment yet, we have a strong labour market and putting aside drought affected industries economic growth is robust...at least for the time being.

Can the All Ords hit 7000 by Dec 07? Who knows? I'm certainly not foolish enough to say it can't. However I would find hard to be fully invested at such levels.

Updates, follow-ups and other stuff 2

Probiotec - not giving much away:
I fired off some questions to management about PBP's 1H07 result. More specifically I was interested in why the company changed their accounting policy for depreciation, how much product development research they intend to capitalize over the coming 6 months and if they intend to continue to pay down debt over the coming six months. Management's comments - depreciation policy was changed as "management believes past depreciation levels were distorting profits negatively" I bet they do. Capex and optimum gearing levels "cannot be discolsed at this time." The company is sticking to their guns about meeting prospectus forecasts and if they don't they can always adjust the amount of capitalized expenses to make it so. I continue to cautiously hold.

PWK - not burning shareholder value:
On February 13th PWK gave the market an update on the progress of the plan (now called 'project runway')to construct a submarine cable linking Sydney to Guam. There was not much in the report to excite the market. What I was impressed with was management's comments that "Pipe Networks will not proceed with the project unless the firm commitments ensure the financial viability of the project. This is in line with our standard investment philosophy and no investment will be made without the support of sufficient final revenue generating contracts." It gives me comfort as a shareholder to know that management is not sucked in to the mentality of seeking growth at any cost.

Reporting season US 4Q06, AUS 1H07
The latest on 4Q06 earnings in the US from Zacks tells us that more than 75% of S&P500 companies have now reported earnings. Surprises outweigh disappointments 3:1 with the median growth in earnings for the quarter standing at a healthy 13%. The point to note is the forecast deterioration in earnings for 1Q07 to a median of 8%.

If anyone can tell me where I can find data like this for the ASX I would love to know. All 1H07 results for June year end companies on the ASX are due by the end of this month. I can't give any definitive commentary on earnings growth rates however below is a table of major companies that have reported to date.

CSL - priced for perfection... and then some

CSL reported a record 1H07 NPAT of $257m, 46% up on the pcp. Eps up 46% dps up 75%. The business continues to perform well and the market thinks so too sending the share price 10% higher to $77.42 at the close today. Whilst a 46% increase in eps and NPAT seems like an excellent result what you don't see in the P&L is the $53.2m (primarily exchange rate differences) witten off directly against equity recorded as a change in reserves in the balance sheet. Once you factor that in the underlying profit is more like $204.1m an increase of 15.7% - nothing to be sneezed at but far more modest than the headline result.

So what if exchange rate difference are written off against equity? Well if you are really interested in calculating the equity value of CSL rather than focussing on earnings then writing off $53m of equity does matter. No doubt CSL runs a well managed profitable business but is the current share price justified? I struggle to come up with a value of more than $35 a share and that's assuming the company can continue to deliver the high returns on equity of recent years into the future. Rather than adding more of this perfect business to your portfolio it could be a perfect time to take some profits.