Why Now is the Time to Watch the Banks

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The US market was closed overnight for the Martin Luther King, Jr holiday. But that didn’t stop the selling in Europe. Stock markets there fell around 0.5%, and the Aussie market is set for another day in the red today.

While the selling will abate at some point, and you’ll see a rally unfold, there is little doubt that you’re seeing a major shift in sentiment. In reality, the shift has been underway for a while. You could argue that 2015 was about a slow change from bullish to bearish sentiment.

A good example of that is the way that the market reacted to China’s latest credit data release, which came out on Friday. The ‘total social financing’ number for December represented the largest credit expansion in about six months.

On the surface that is a bullish number. It shows that credit continues to expand in the Chinese economy, despite all the problems it faces. 12 months ago, the market would have reacted in a bullish fashion. But this time around, that wasn’t the case.

It turned out that a big part of the jump in December credit came from the shadow banking system. The market viewed this as bearish, because it means that risks in China’s financial markets continue to grow. More than likely, it reflects distressed companies turning to opaque sources for credit, all in an attempt to keep their head above water for a little longer.

A bullish market will ignore this risk and celebrate the party going for a little longer. But when sentiment is bearish, it sees things differently…more realistically.

That’s where I think we are now. And if I’m right, it reflects an important shift. It means 2016 will be just as tough, if not tougher, to make money than it was in 2015.

But it’s not impossible of course. It’s just that the same stocks of years gone by — the household names — won’t do it for you. Look at the stocks that bombed last year. Woolies, the banks, BHP, Rio and the major energy players like Santos and Origin. A few years ago they would have been in every self-respecting investor’s portfolio.

But markets are funny. Stocks that end up performing well often don’t make you feel so good when you first buy them. Shunning household names last year was a very good thing to do, even though it may not have seemed like it in foresight.

That’s what saw fund manager Bennelong deliver the best performance among its peers last year. As the Financial Review reports:

Steering completely clear of resource stocks, a relatively small exposure to bank stocks, favouring the healthcare sector, and a handful of big bets on smaller companies with savvy management teams were the main drivers of Bennelong’s success in 2015.

Earning a decent return from the market was difficult last year. It will be difficult again in 2016. You need to think outside of the box. Smaller stocks will probably do better than bigger stocks.

Australia’s large companies are dominated by rent seeking financials or participants of a duopoly. As economic growth slows and a recession looks likely, these companies will find it hard to generate earnings growth. No earnings growth means no share price growth.

Small stocks on the other hard should continue to find opportunities to grow. Our small cap investigator Sam Volkering has identified a handful of these stocks…he calls them shockproof. If you’re interested in trying to get an edge in 2016, check out his presentation here.

Despite this visible shift in investor sentiment, the mainstream press doesn’t get it. Bloomberg has a headline ‘Davos veterans say stop worrying about China’s market meltdown’.

Look, the Davos snout-in-the-trough-fest is the biggest gathering of financial elites in the world. They’ll tell you what’s good for them, not for you. You can safely ignore anything that comes out of that infested little Swiss mountain village over the next few weeks.

Even Adam Creighton at The Australian, who usually writes pretty good stuff, is confusing the issue:

Since New Year’s Day Australia’s blue-chip stocks have sunk almost 10 per cent, reflecting similar falls in Europe and the US. While Australians were enjoying their summer BBQs, the real discounted future flow of expected company earnings (what share prices are broadly meant to reflect) very noticeably collapsed.

The apparent cause? Further falls in the prices of shares in China’s Shanghai exchange, tweaks to the value of the yuan, and an unexpectedly low oil price below $US30 a barrel. Yet these factors don’t justify the latest sell-off. Little that actually matters in the real economy has changed (or even could have changed in so short a time).

As I said yesterday, the markets move ahead of the real economy. The real economy doesn’t lead the market. It’s naïve and dangerous to think otherwise.

So when you read commentary that says, ‘the fundamentals haven’t changed’, be wary. The market moves over the past few weeks are a sign that something has changed.

The market is the best fortune teller you have. Ignore it at your peril.

Here’s something that has changed in Australia over the past few months…mortgage activity. Demand for mortgages is at a three year low, as the Financial Review reports:

Mortgage activity has dropped to a three-year low, suggesting the housing market is unlikely to pick up to its former frenetic pace when the current seasonal slowdown ends.

CoreLogic RP Data’s Mortgage Index, which registers mortgage-related activity across the data provider’s platforms, halved in value from a month earlier to 70.1 in the week to Sunday. This was well below the 99.2 of the equivalent week a year ago and was the lowest reading since January 2013.

December/January always represents a seasonal slowdown in mortgage demand. But this time, the slowdown is big. The credit tightening brought about by APRA last year is working. Will China’s issues continue to act as a brake on mortgage demand and house prices this year?

For an answer to that question, listen to the market, not the opinion of vested interests. Specifically, keep an eye on the banks. They have the most to lose if house prices begin to fall.

Greg Canavan,

For The Daily Reckoning

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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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