What this Company Says about Australia’s Prospects in the Months Ahead

Girl counting Australian money
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US stocks finally stopped for a breather overnight, ending the longest winning streak in the Dow Jones Index since 2013.

Earnings news from Intel, American Express and Southwest Airlines disappointed, and dragged the market lower. Which is weird, because I didn’t think investors were too concerned about earnings anymore.

Bloomberg reports that the S&P 500 traded on a price-to-earnings (P/E) ratio above 20 for the first time in seven years last week. Seven years ago it was 2009. US corporate earnings had just gone through a massive crunch.

It made sense for the market to trade on a high PE multiple back then. It correctly anticipated a big rebound in earnings in years to come. In other words, when earnings rise strongly, a high P/E market isn’t necessarily expensive.

But here we are now, deep into a business cycle, and the S&P 500 is back trading on a high P/E. Earnings are going nowhere. What growth there is certainly isn’t enough to justify such lofty expectations.

But it’s not just about expected earnings for stocks. It’s about alternative investment options. There aren’t too many.

Sovereign bond yields pretty much just give you your money back after inflation, if you’re lucky. The S&P 500 trading on a P/E of 20 equates to an earnings yield of 5%, which doesn’t seem too bad an option if you’re a big pension fund desperate for returns.

And when you’re desperate for returns, you tend to ignore risk. Which is what has been happening for a while now. And will likely continue well into the future. At least as long as central banks try to control the market through words and monetary deeds.

While stocks fell, gold bounced back from yesterday’s losses. It’s now around US$1,330 an ounce, or $1,774 an ounce in Aussie dollars. In yesterday’s trade in Australia, gold stocks were the biggest losers.

I’ve been talking about the coming correction in gold, and yesterday you saw a bit of capitulation selling. Many quality gold stocks fell between 5–10%. I hope the falls didn’t freak you out too much. This correction has been in the works for a while.

To help take advantage of this, I’ve prepared a special report highlighting what I think are the top five gold stocks on the Aussie market. More importantly, I provide what I think is the buying ‘sweet spot’ for these stocks during this correction. After yesterday’s sharp sell-off, many of these stocks hit their sweet spot.

With gold having bounced overnight, no doubt you’ll see the sector rise strongly today. But that doesn’t mean the correction is over. I reckon it still has a few weeks to play out. To access the report and find out which stocks to buy at what price, click here.

Here’s another reason to like gold longer term. Credit rating agency Standard and Poor’s just released a disturbing new report showing projected corporate credit growth to 2020.

It expects corporate debt to expand US$24 trillion over the next four years, thanks to low interest rates and ongoing central bank debt monetisation. Not surprisingly, S&P expect the lions’ share of the new credit growth to come from China.

As the chart below shows, China’s share of the credit pie will climb to 43% from 35%. It will be responsible for 62% of the new credit growth.


Source: The Daily Shot
[Click to enlarge]

That’s a real risk, given China’s corporate debt market is already massive. In fact, the report states that more than half of the expected credit growth will come from already highly leveraged players.

It’s probably no surprise that a lot of this growth is coming from China, then. Corporates, especially ‘state-owned enterprises’, borrow heavily in the knowledge that the government will bail them out if need be.

Right now, fear of default is not a big concern in China as it’s going through another one of its short lived growth spurts. But as the chart below shows, much of the recent growth is the result of a huge increase in government infrastructure spending.


Source: Haver Analytics, Barclays Research
[Click to enlarge]

That’s represented by the dark blue line, ‘public sector FAI’, which stands for fixed asset investment. If you’re wondering why the iron ore price has held up, or why the Aussie dollar has been so resilient, this big spike in government fixed asset spending is your answer.

As the chart illustrates, the spike is on par with the huge 2008/09 stimulus program. That resulted in an iron ore boom and helped Australia avoid the worst of the global recession.

But it didn’t last, and neither will this one. Worryingly for Australia, this latest round of stimulus hasn’t really done too much. That’s because private sector investment continues to fall sharply, meaning overall fixed asset investment is declining too.

What happens when the government’s latest stimulus efforts run out of puff? It seems pretty obvious to me. As far as Australia is concerned, iron ore prices will tumble back to their lows, and the Aussie dollar will head south too. The Aussie government’s budget plans will again be under pressure.

We could still be a few months away from this reality though. I like to use Fortescue’s [ASX:FMG] share price as a barometer for the iron ore market. And as you can see in the chart below…right now it’s doing well.


Source: The Daily Shot
[Click to enlarge]

A fall back below $3.50 would indicate that the run is coming to an end. It could be a warning that conditions are changing in the iron ore market, and much lower prices are on their way. So keep an eye on FMG, it will tell you quite a lot about Australia’s prospects in the months to come.

Regards,

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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