Why You Need to Keep an Eye on ‘Australia’s’ Share Price

Businessman holding money  - Australian dollars
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[ED Note: If you haven’t downloaded your copy of Vern Gowdie’s ‘End of Australia’ yet, be sure to do so here. Many of Vern’s predictions are playing out in the markets right now. And in his latest presentation, Vern provides an update on his thinking. Check it out here.]

In yesterday’s Daily Reckoning I showed you how a number of housing exposed stocks were all hitting, or were very close to, multi-year lows.

The big daddy in that list was the Commonwealth Bank [ASX:CBA]. Well, yesterday, CBA hit a new, intra-day 12-month low, before buying interest came in. The stock closed down only 26 cents, having been over $1 a share lower in earlier trading.

I’ll have a look at what this means in a moment. But first, a quick look at the markets.

European shares gained more than 2% overnight, for no particular reason. US stocks had a strong session too. At the time of writing, the Dow and S&P500 were up nearly 1%.

The gains came after China’s Shanghai market plunged more than 6% yesterday. While China and its currency woes have been lying low recently, the Middle Kingdom still has plenty of problems.

Simply put, China’s economy is slowing down, which makes it harder for it to service its dangerously growing debt pile. Ominously, world trade is slowing too. From the Financial Times:

Weaker demand from emerging markets made 2015 the worst year for world trade since the aftermath of the global financial crisis, highlighting rising fears about the health of the global economy. 

The value of goods that crossed international borders last year fell 13.8 per cent in dollar terms — the first contraction since 2009 — according to the Netherlands Bureau of Economic Policy Analysis’s World Trade Monitor. Much of the slump was due to a slowdown in China and other emerging economies.

While everyone is seemingly worried about another credit crisis, this slowdown in world trade is the most obvious reason behind this year’s stock sell-off. That’s not to say things won’t escalate and get worse, but often the simplest explanation is the best one.

That is, global stock markets are in bearish trends because last year they were priced for strong growth (and magical central bank powers). But now, a China led slowdown has altered this rosy view of the world. Stocks valuations are adjusting to a lower growth global economy.

Where things could get ugly is if the slowdown persists. There is now so much debt in the world that any decent slowdown would wreak havoc on equity prices.

Think about the global economy as an individual. If a person adds debt all the time, they need to grow income to service the increasing debt pile. If income growth stops (that is, no global economic growth) then the pressure to service that debt becomes intense.

Keep in mind this individual’s ‘balance sheet’ isn’t at all healthy. It’s loaded with debt and supported by only a small amount of equity. When you’re running a balance sheet of such dubious quality, and income growth slows or stops, the value of the equity cops it.

This is just a technical way of saying that equity prices will fall when growth slows in a highly leveraged economy. That’s hardly a revelation, is it?

Well, not when you put it that way. But it is a revelation for those who don’t think about things in this way.

Which brings us back to the CBA. It’s a highly leveraged institution. As at 31 December, it had around $60 billion in equity supporting $900 billion in assets. And who knows how much ‘off balance sheet’ debt there is. In other words, if the value of the balance sheet assets falls by 6.66%, CBA’s shareholders will be wiped out.

That’s a low probability outcome, but it’s certainly not impossible. For years, the market priced CBA for ongoing growth and ongoing record profitability. Now, investors are beginning to question this assumption, which is why the share price is falling.

As I showed you yesterday, a number of housing and mortgage related stocks point to a coming slowdown in the market. That will flow onto the banks in the form of slower debt growth.

And, as I pointed out above, when income growth slows for a highly leveraged company, country, or individual, equity values will take a hit.

That’s exactly what is happening to CBA right now. Let’s have a look at the chart again. By the way, I focus on CBA because it is the ‘leader’ of the Aussie economy. It is the best bank in the sector in terms of market share and leadership. So when CBA goes down, you know the whole ship is sinking.

In addition to that, CBA is a good reflection of the modern Aussie economy. That is, a debt growth dependent and asset speculation based economy. Once these things go, there isn’t much holding growth up right now.

So think of CBA’s share price as the market’s verdict on Australia. Right now, it’s hanging on by the skin of its teeth. Here’s a 10-year weekly chart for Australia/CBA:

Source: BigCharts

As you can see, the credit crisis of 2008 inflicted some damage but thanks to monetary and fiscal policy, and of course China, we quickly recovered.

The potential blow up of the Eurozone in 2011, as well as high interest rates here, kept a lid on share price growth for a while. But the RBA’s rate cutting cycle ended all that. For the next few years Australia/CBA shot higher, riding the back of a debt-fuelled housing boom.

But now the party is over. Australia/CBA sits on critical support levels. $70 is the line in the sand. If that level breaks, CBA is going lower, and quickly.

I’ll show you why $70 is so crucial. The 2011 low was around $43. The early 2015 high was about $96. That represents a big rally of $53 per share.

In bullish long term trends, it is not unusual for stocks to retrace half the gains from the earlier move. This is a very common chart pattern and reflects human behaviour. So it is not unusual to see CBA correct lower after such a strong run.

Now, $70 represents the mid-point of the 2011–2015 rally. That’s why buying support came in last year, and why you’re seeing it again now. $70 represents strong support.

If $70 doesn’t hold, it’s telling you Australia’s economic model is toast. So keep a close eye on Australia/CBA. This share price will tell you more about the future of Australia than a month of reading useless opinion articles.

Greg Canavan,

For The Daily Reckoning

Editor’s Note: If you haven’t been on to our Facebook or YouTube page recently you have missed out on a series of short video updates from our publisher, Kris Sayce. The latest video is a blooper reel from the last few months. You can watch it here.

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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