20 signs of hope for the sharemarket

In the interests of being hopeful rather than hopeless, here are signs of market hope in the shorter term.

1. Citigroup has been saved.
2. Every large financial that could have failed has failed.
3. Credit spreads are improving slightly. (Remember; the debt markets led the equity markets.)
4. Counterparty risk is starting to fall.
5. The oil price has fallen by $US100 a barrel, which is the equivalent of a $US200 billion stimulus for the US economy.
6. Interest rates are being slashed and will continue to be slashed.
7. Equity risk premiums are at record highs versus bonds.
8. We are about to wave goodbye to George W Bush and his cronies.
9. We are about to wave hello to Barack Obama.
10. The Chinese will implement further stimulus packages aimed at infrastructure.
11. The US will implement further stimulus packages aimed at infrastructure.
12. Australia will implement further stimulus packages aimed at infrastructure.
13. The average Australian with the median mortgage and a car is $454 a month better off due to falling interest rates and falling petrol prices.
14. ANZ and Westpac’s dividend reinvestment plans are coming to an end.
15. The equity raising window in Australia is now shut until after Christmas (QBE will be the last big one).
16. The Chinese cut rates by 108 basis points.
17. The AGM season is coming to an end (no more hose-downs until February).
18. “Scarebroking” is now consensus.
19. BHP Billiton has walked away from Rio Tinto.
20. I have taken Babcock & Brown (BNB) off my watch list.

I caught a taxi into town yesterday and I made the fatal mistake of saying “yes” to the driver’s question whether I “worked in the markets?”

I would have thought that was a rhetorical question when I asked to go to Chifley Tower and spent the first few minutes of the trip looking at my BlackBerry. Apparently it wasn’t, and when I confirmed that I did work in financial markets it triggered one of the greatest outbursts of market theory I have ever experienced. Luckily I only live a short distance from the city.

Of course, just about the last thing I need right now is an early morning lecture from a taxi driver on market theory. However, as part of judging overall sentiment I try to listen to all views on the market.

Amazingly, less than 48 hours after I had written about bond prices being a bubble, I was listening to a high-conviction argument on why the only thing to invest in were government long bonds and how equities would fall “another 40%”. I politely listened to this opinion, paid the exact fare and then wrote in my diary “bond bubble confirmed, taxi driver bullish on bonds”.

Again, I think this confirmed my theory that advances in telecommunications mean that “bad news travels faster than at any time in modern history”. When taxi drivers (and this isn’t a shot at taxi drivers, as I think they are a good barometer of the populations’ views) are telling me the only thing to do is buy government bonds on 50-year low yields I know it is time to take some risk.

But with equity risk premiums at levels not seen in generations, I am getting paid to take the risk in equities over bonds. The equity risk premium is massive, even if you don’t believe the “e” of the inverse P/E equation that derives earnings yield in the equity market.

I just fail to believe that buying an Australian government five-year bond on a yield of less than 4% (unfranked) or a US 10-year bond yielding under 3% is what I should be doing with my cash. If I assume inflation is running at 3% then the “real” return from that investment is negligible. Clearly, those buying bonds at these very low yields are solely seeking capital protection.

Cash rates getting feeble

Interestingly, earlier in the week I got a letter from the Commonwealth Bank, saying it had made an error in the rate they had shown on some money I have “at call” with them. They had mistakenly forgotten to reduce the “at call” published rate by the recent Reserve Bank cash rate reduction. The new “at call” rate was 4.75%, and I couldn’t help thinking to myself “why on earth do I have any cash on deposit at that rate?” It’s just me providing cheap funding to the CBA!

If I can’t beat an annualised 4.75% (unfranked) return somewhere in the Australian equity market from these grossly oversold levels then I may as well give up. Those “at call” cash rates are only likely to decline further in December and February as the Reserve Bank takes the cash rate to 4% or slightly below. Clearly, as that occurs people are going to be forced to look for alternatives to cash as the income generated by cash collapses. This could well coincide with people becoming less obsessed with capital protection.

Of course the letter about my “at call” deposit rate came on the same day the Australian equity market almost matched that annual deposit rate, with a daily gain of 4%, while many leading stocks were up more on the day than the annualised “at call” rate.

What we all forget is that the market and leading stock prices have been so destroyed that percentage gains off these very low levels can be very strong. Small absolute share price gains equate to large percentages and it doesn’t take much to generate a return “better than cash” with well-timed trades and the selective use of options (volatility remains high).

I get the feeling I am not alone looking at any cash I have on deposit and thinking to myself “I should be doing more with that cash; I should be braver”. Yet human psychology for some reason tends to push me towards wanting to buy with the company of others. I know it’s absolutely wrong and I shouldn’t be fearful of being a lonely buyer, but human nature dictates this response even if that means you missed the absolute peak of opportunity.

Cash; when will it be deployed?

I speak to a lot of financial planners and there is cash in the system waiting to find a higher risk home. Cash on deposit in cash management trusts, bonds, bills and the like has been rising over the past three months. The timing of when this cash does come in from the sidelines is debatable, but it will at some stage.

The vast bulk of the conversations I have with private investors and financial planners come to the conclusion that “I’d rather buy 10% off the bottom knowing we had seen the bottom”. That’s the old “falling knife theory” and it seems it has become commonplace. Just about the whole world is “waiting for the knife to stick” and that is a pretty interesting development.

The problem with “waiting for the knife to stick” is that you only truly know it has after the event. The speed and efficiency of markets, due to telecommunications and the availability if information, means that you will have to be incredibly nimble to truly implement the “knife sticks” strategy. Markets may well be 15% above their lows, which is quite feasible, considering the very low base we are coming off, in very quick time, and the “knife sticks” strategy may actually backfire.

While I truly hope global markets are attempting some sort of bottoming process, I also believe this will be an extended process with heavy intraday and intraweek volatility. You simply can’t have events as serious as Citigroup failing – and, let’s face it, they did technically fail (and then were rescued) – and just wake up the next morning and everything’s rosy again.

Even optimists such as myself acknowledge the unprecedented seriousness of the events we are witnessing and realise any recovery process will be extended and bumpy. While I absolutely believe bonds are a bubble, in fact cash is a bubble, and equities are grossly oversold, that doesn’t mean the recovery in equities will be without headwinds or speed humps.

Speed humps

We have run into quite a few stock-specific speed humps this week as corporate Australia confirms revenue, cashflow and/or balance sheet weakness. Suncorp-Metway, Qantas, Brambles, Harvey Norman and OZ Minerals have all formally confirmed what the market already knew, but that didn’t stop the stock prices underperforming further as four out of five could be shorted. Most of these stock prices are down 50% to 80% from their peaks, yet confirmation of poor trading conditions did see further share price weakness, which was a bit of surprise to me.

While the February 2009 interim reporting season is more than two months away, and two months in these markets is an eternity, it still concerns me that the interim reporting season will broadly be a shocker. Previous corresponding period comparisons will be awful and the headlines and outlook statements will be neutral at best.

Nobody will be brave enough to give formal guidance and analysts will be forced to cut their still wildly optimistic bottom-up forecasts. There’s no doubt in my mind that the interim reporting season will provide a “reality check” to the Australian market and will clearly be a “speed hump” in the domestic equity market recovery process.

In the short-term, I can’t help but think that Citigroup’s failure and subsequent rescue will mark some sort of peak in risk-aversion. You can see that the reaction to Citigroup’s rescue has been aggressive short-covering in perceived higher risk equities, particularly cyclical equities. The upward moves on this short-covering in risk have been spectacular, yet off low bases.

Citigroup; the biggest tree in the financial forest

Citigroup has been the biggest tree in the financial forest. Its collapse would have had implications beyond calculation, but its rescue should see risk-aversion drop a notch or two. I’d go as far as to say there is nothing else I can think of that could fail from this point that would or could have wider and more devastating implications that Citigroup’s failure would have had.

Perhaps GE, but it will survive in some form too. The point is now that Citigroup is “saved”, there’s no bigger domino to fall in my view that could have caused as much market disruption or dislocation.

Clearly Citigroup’s “failure” is a monumental event, which again reinforces what a monumental and unprecedented mess we are in; but the fact it was saved is a positive for risk tolerance and more importantly counterparty risk. Trading bottoms in markets are always marked by a monumental event and I can’t help but think Citigroup’s failure and subsequent rescue will mark a trading bottom in global markets and a trading peak in risk-aversion.

We all know the economic and earnings data is bad and most likely still getting worse, yet the last leg down in markets was driven by counterparty contagion fears surrounding Citigroup. In my view, markets will now price out that severe counterparty contagion view and you will see perceived risk continue to outperform. Clearly, as you can see from this week’s price action, the most crowded short trade in the world is short global cyclicals. The most crowded long trade in the world is government bonds.

The biggest trading rallies of all are in bear markets from grossly oversold levels. They are the most violent and tradeable rallies you will ever see. I just feel the current one may have a little more to it and we may actually get the Christmas rally and “Obama rally” into his inauguration on 20 January.

Let’s face it; markets have lost all faith in the current US administration, Henry Paulson included, and the new broom, or anticipation of a new broom, in Washington must be a positive for markets simply because it’s not a negative.

My theory, although it has proved premature due to the Citigroup incident, is that there will be a tradeable “Obama rally” into his inauguration. Late January may see the peak of that rally and then we would look to take trading profits in risk ahead of what will be a disappointing dose of reality from the domestic interim reporting season.

20 signs of “hope”

So while my taxi driver friend can only see safety in government bonds, I think there are signs of a few better trading months coming in risk equities. We all know the negatives; and I acknowledge the negatives are serious, but there are positives in the system that markets are refusing to price in at this stage.

My number one recommendation for a two-month rally in cyclical risk remains BHP Billiton in resources and ANZ in financials. Buying ANZ from the dividend reinvestment plan is my top financial sector idea. I will reassess these trading ideas before the interim reporting season in February, but I’ll be very surprised if we can’t beat cash.

It is time to be a touch braver because the massive equity risk premium is paying you for that risk.

Charlie Aitken, the head of institutional dealing at Southern Cross Equities, may have interests in any of the stocks mentioned.

This article first appeared on Eureka Report