In today’s Daily Reckoning take up the question of whether Australian stocks are undervalued and whether price-to-earnings ratios are useful at all when you’re analysing cyclical stocks. There is also the little issue of whether Aussie stocks could be “de-risked” by the result of the Federal election and whether that is a tradeable event.
A note on gold first, though. “China has moved to liberalise its gold market further, increasing the number of banks allowed to trade bullion internationally and announcing measures that will encourage development of gold-linked investment products,” reports the FT‘s Leslie Hook in Beijing.
Chinese investors bought 73 tonnes of gold last year, according to the FT. That was up from 18 the year before. According to our maths, that’s a 315% increase in demand from retail Chinese investors. Maybe this is the domestic demand being unleashed that everyone’s been waiting for!
More seirously, the gradual liberalisation of capital rules in China has unpredictable consequences. China is the world’s largest producer of gold and the second-largest consumer behind India. But keep in mind that as recently as 2008, China’s savings-rate-to-GDP ratio was nearly 52%, according to People’s Bank Monetary Policy Committee Member Fan Gang.
It is believed/hoped for that this “glut” of Chinese savings is both responsible for economic imbalances in the world and also the future salvation of global growth. But would it surprise you if middle class investors in China choose to store some of their wealth in bullion instead of plasma televisions?
That is, they might, if given the choice, turn paper into bullion instead of turning paper into plasma. It just depends on the cultural attitude toward risk, toward affluence, and, of course, toward gold.
Meanwhile, gold futures got up off the matt in trading at the New York Mercantile Exchange and traded at $1,185.20. Cop that gold bears. And even while the bullion price is consolidating, it would not surprise us to see a rally soon in major gold producers. But that is a topic we’re saving for a weekly update to Australian Wealth Gameplan subscribers.
Here in this free space we would draw your attention to the crashing bond yields in the United States and Japan and the corollary to those events; the resumption of hot money risk trades that could drive up commodity currencies, commodity futures, and resource equities. It is madness. But it’s worth a look.
First up is the fact that two-year Treasury yields in the U.S. again fell to record lows in New York trading. Yields fell to just 51 basis points during trading before settling at 54 basis points – or just about half a percent in interest for loaning money to the American government for two years. In Japan, the yield on the 10-year government bond fell below 1% for the first time since 2003, or about the same time the huge liquidity driven rally in all asset classes kicked off last time. What gives?
Well, traders may be anticipating more Quantitative Easing from the Fed and are now simply getting ahead of the game by buying Treasuries before the Fed does. The idea for more QE was floated in a paper in late July by St. Louis Fed President James Bullard. The Wall Street Journal is also reporting that the Fed may invest profits from its portfolio of maturing mortgage securities right back into the Treasury bonds.
What do we have here then? On the one hand you seem to have investors and the Fed conceding that growth in the developed Western industrial economies (including Japan) is sub-par. They’re ditching equities and favouring short-term sovereign debt as the way to beat deflation in other asset markets.
On the other hand, we know that short-term rates in Japan and the United States are just the sort of thing to set off speculators looking to borrow cheap and seek risk and high yield. If you can’t make anything on bank interest, you go off in search of junk. And oh by the way, did you know that wheat futures are up 62% in the last month?
This led us to ask Slipstream Trader Murray Dawes if his charts were showing him evidence that hot money flows were boosting commodity futures. He said it sure looked like it. And from there the conversation progressed to whether this evidence, along with the Federal election here in Australia, made a case for being a very short-term bull on Australian resource shares.
Usually elections are not tradeable events, unless there is a clear policy proposal that will hurt or help a specific industry. In Australia, for example, you could argue that a Liberal victory at the polls will hurt renewable energy stocks (presuming the carbon tax dies a richly deserved death). That policy change might hurt renewable energy stocks that suck off the government development teat. According to the ALTEXGreen Renewable Energy Index, renewable energy shares were up 33.3% last year but are down 14.5% this year.
This is probably a case of “buy the rumour, sell the news.” That is, the markets may have already discounted a Liberal win at the polls. Then again, the scrapping of the Mineral Resource Rent Tax (MRRT) altogether could “de-risk” Australia enough in the eyes of foreign speculators that the big resource shares (and some of the little ones) get a boost.
But a trading strategy based on the outcome of a political contest is probably a losing trading strategy. Your best bet is to look at each business on a case-by-case basis and evaluate it (or value it) on its merits. Dr. Alex Cowie is busy doing so out at the Diggers and Dealers show in Kalgoorlie and this morning we saw the most recent issue of the Australian Small Cap Investigator as it gets ready to go out the door this afternoon after the market closes.
Besides, it doesn’t make much sense to use metrics on the overall market to time your entry and exit positions in individual shares, by our reckoning. Take price to earnings ratios. According to an article by Stephen Shore in yesterday’s Australian Financial Review, the forward P/E ratio for the Aussie market is around 11.5 right now. That’s well below its average of about 15 times forward earnings from 1990-2010.
In an era of low inflation and high GDP growth, investors are prepared to pay more for stocks because earnings grow much faster than inflation. And expectations during credit-fuelled growth are generally for more growth. But in a credit depression, growth expectations shift. So does the current lower-than-average P/E tell you it’s time to buy or sell Aussie stocks? Not so fast!
“A lower than average P/E,” writes Shore, “is usually a sign investors are worried that companies’ earnings will fall short of forecasts. Another possibility is that the relative economic stability enjoyed in recent decades has come to an end, and the market has undergone a structural shift to a new normal of a lower P/E ratio.”
This “new normal” sounds a lot like the “new normal” PIMCO bond manager Bill Gross has written about. In that “new normal,” investors prepare for lower economic growth and take fewer risks. But if fortune favours the bold, should you think about buying the market, or at least the best stocks in the market, anyway?
“Some investors are concerned Australia could be entering a situation similar to that of the 1970s, where shorter, sharper cycles for earnings caused the market to trade at a lower P/E. Australia trades at a discount to Canada and the US, despite no obvious signs that the risk to future earnings in Australia are any higher,” Shore writes.
There is, of course, an obvious risk to future earnings in Australia in the form of the MRRT. Thus, the scrapping of the MRRT might “de-risk” the market enough to lead to a snap back in forward P/E ratios and a nifty and nimble little trade. But that is not our game.
That is, forward earnings estimates are mostly rubbish in a market dominated by resource stocks. There is too much cyclicality and volatility for companies in capital intensive extractive industries to give you realistic “visibility” about what commodity prices are going to be five years out, and thus what earnings will be. Costs routinely explode to the high side at the peak of the commodity cycle. Thus, the overall P/E on the Aussie market is pretty useless in guiding your individual decisions on resource shares.
Where you go from there is a matter of preference. Of course you have to construct valuations for prospective investments, otherwise you’re just gambling. Our guys establish valuations for their recommendations all the time here. But they are general guides with giant concessions to a huge array of variables (known and unknown). The only upside to investing with so much uncertainty about a particular company or a commodity is that you can make a lot of money if you get it right.
That leads us, finally to a point we made earlier in the week that we need to clarify. The issue is whether any of the editors at Port Phillip Publishing directly own or trade the shares they recommend to readers.
On Monday we wrote, “For the record, ASI editor Kris Sayce sold out of the Linc position in February of this year. When he sold, the stock was up 122% from the original share price. Kris managed to bank gains on the stock, even though the business itself has yet to generate cash-flow in the way your editor described in the original story. That’s the world of speculation, where you take your gains when you have them”
Kris didn’t sell out of the Linc position himself because he doesn’t own any Linc shares. In fact, no one employed by Port Phillip Publishing can trade in the shares recommended by the editors. We’ve voluntarily adopted this policy so that we can avoid the appearance that we’re profiting by recommending shares we also own. When we wrote that “Kris managed to bank gains” we meant that readers of the Australian Small Cap Investigator could have banked gains had they bought and sold the shares following Kris’ recommendations.
To be honest, it’s not the most popular policy among staff, nor is it legally required. We could own the shares we write about as long as we disclosed it. And there’s an understandable argument that a share recommendation has more credibility if the editor puts his money where his mouth is. So why not allow it?
It keeps things simple and direct. For one, the buy and sell recommendations made by editors are not compromised by any personal emotional or financial interest in the share. It keeps them objective. More importantly, it keeps the business relationship clear: our editors are paid full time (and well) to research and write the kind of stories that they probably wouldn’t be allowed to write anywhere else.
Their compensation, and really the whole firm’s viability, hinges on whether you find the work we do useful and profitable. We don’t make management fees because we don’t manage money. And we don’t profit by trading the shares we recommend. We only make money if readers find our ideas intriguing enough to subscribe to a service and useful enough to continue subscribing. Clean, transparent, and without any hidden incentives. And if that is not good enough for you, it’s hard to imagine what is!
for The Daily Reckoning Australia