A Universal Law of Life and Financial Markets

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The Australian share market, as represented by the ASX 200 index, had a shocker on Friday. It fell 1.6% and is now back around the 5000-point level. The banking sector is the reason behind the market’s recent weakness.

After bottoming in late February, the sector enjoyed a strong bounce in March. This helped push the ASX 200 back up to around 5200 points. But worries about bad debts, and the banks’ exposure to property, are weighing on investors’ minds.

In particular, it looks as though the property apartment market has turned. As reported in the Weekend Financial Review:

The long-anticipated slowdown is now hitting Melbourne’s apartment market and that means many buyers of dwellings in the city centre – which has led the country’s shift towards denser living – can kiss goodbye to their hopes of capital growth for the assets that are already delivering anaemic rental incomes.

The biggest risk here is that it increases settlement risk on thousands of apartments that are currently under construction. Developers obtain finance from projects by pre-selling apartments. They take a deposit from the purchaser and borrow the rest. Upon completion, the purchaser pays the remainder to the developer, who repays the loan to the bank and (hopefully) earns a profit.

But if prices continue to fall, some buyers might forgo their deposit and walk away. Or some just might not be able to borrow the funds required to complete the purchase if credit conditions have changed.

If developers get into trouble it increases the risk of rising bad debts for the banks, hence their recent share price weakness.

Bank share prices are now heading back to the lows of late February. Will the lows hold? If they don’t, I think it will confirm that rising bad debts will hurt future earnings and put the current juicy dividends under pressure.

The two weakest banks, ANZ Bank [ASX:ANZ] and NAB [ASX:NAB], trade on prospective dividend yields of around 7.5%, fully franked. On the surface, they look like solid buys.

But whenever a stock trades on a fat dividend yield, you need to be wary. More often than not, it’s the market pricing in a future dividend cut. But no job-fearing analyst will predict bank dividend cuts until its all but staring them in the face.

So when you look at forecast dividend yields, keep in mind you’re looking at the forecasts of analysts who, as a groups, ALWAYS move after it’s too late.

That’s why it’s very important for you to focus on the chart. A stock price chart will tell you what’s going on ahead of time; you just need to learn how to read it.

In this case, keep an eye on the banks and their lows from late February. If prices close below these lows, you can expect to hear future news about rising bad bets and dividend cuts. But when it’s in the headlines, it’ll be too late to profit.

More immediately though, that’s not likely to be a huge issue for the market. A strong US jobs report on Friday, which saw 214,000 positions created in March, sent stock prices higher. The Aussie market is set to have a bit of a bounce.

Normally, investors would interpret strong employment growth as bad news, because it would increase the prospect of interest rate rises. But the strong employment numbers came on the back of Fed boss Janet Yellen’s speech last week, which took great pains to point out that the Fed would only move very slowly in increasing interest rates…in case there was ever any doubt.

But she did more than that. She told markets that, if need be, the Fed will drop interest rates again and turn the Quantitative Easing (QE) spigot back on. From Yellen’s speech:

Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation.

In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.

While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Needless to say, investors love this environment. But I wonder if Yellen is maybe anticipating future economic weakness and trying to coach the market into pricing in more QE in such a scenario.

It’s the ultimate in central bank market management. That is, tell the market the Fed will meet economic strength with slow and reluctant monetary tightening, but, in reality, respond to economic weakness with extreme easing.

The market will never go down again!

That’s the Fed plan. But it won’t work out like that. You can’t try and play God with financial markets. It is but a reflection of human nature. Therefore, it’s not rational.

Rather, human emotions, and the underlying laws of human nature, govern the market. One of these is the law of cause and effect, also known as polarity. That is, for every action there is a reaction. For every positive there is a negative.

This is nature’s way of maintaining balance. It manifests in all things.

The Fed is fighting this basic universal law. There will be reactions to its actions; we just don’t know what the ultimate reaction will be.

It’s not just the Fed, of course. Every central bank and government on Earth is doing their best to bend financial markets and economies to their will. Look no further than China. Here’s a good example of cause and effect, from the Wall Street Journal:

China’s efforts to tackle a glut of vacant housing by spurring home lending have triggered a bigger problem: A surge in risky subprime-style loans that is generating alarm among regulators.’

You’ve got to give it to China’s central planners. They don’t give up. First, they fostered and encouraged an epic, nationwide house price bubble. When that faltered, they ‘cheerled’ the stock market into a mini-bubble.

Soon after, that bubble popped and now they’re back flogging the property market. Not quite a dead horse yet, but it’s only the top-tier cities enjoying big prices rises in China.

How long until you see the reaction here?

And the flow on effect to Australia?

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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