Aussie stocks fell sharply yesterday. It was the biggest decline in five months. A worse than expected earnings result from BHP Billiton Ltd [ASX:BHP] unnerved investors, and the prospect of more political uncertainty didn’t help matters either.
The Libs are at it again trying to roll Malcolm Turnbull. This time Peter Dutton is having a crack. Turnbull won yesterday’s party room vote, but it probably won’t be the last. The hounds are circling again.
That means political stability and the absence of leadership will continue to elude Australia. It’s been like this ever since the credit crisis of 2008. Maybe the final punishment is that we end up with Bill Shorten in charge?
Getting back to the markets, you’ll recall that yesterday I said that it’s important to watch the market’s reaction to the results, and not so much the result itself.
In the case of BHP, underlying earnings jumped 33%, but the share price fell nearly 2% on the news. That tells you the market already knew BHP would deliver a big earnings jump, thanks to strongly rising commodity prices over the past year.
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As Good As It Gets?
Is this as good as it gets for BHP?
It’s still too early to tell. Analysts expect the company to increase earnings per share by around 8% in FY19. Based on the current market price, BHP trades on a price-to-earnings ratio of around 14 times FY19 earnings forecasts.
That’s not overly expensive. Not on the surface anyway. But earnings estimates can change dramatically for companies exposed to commodity prices. What looks like good value near the top of the cycle can all of a sudden be very expensive.
Say for example commodity price fall 20% across the board, which (ignoring other factors like production levels and operation leverage) leads to a 20% fall in earnings estimates.
In this scenario, BHP all of a sudden goes from trading at a reasonable 14 times forecast earnings to around 19 times forecast earnings.
While the market’s reaction to BHP’s FY18 numbers wasn’t great, it’s too early to get bearish. As the chart below shows, BHP is still in a healthy upward trend. A fall below support around $32 will call that into question, and it may suggest BHP’s bull run (which started in January 2016) is done for now.
Another point to note here is that volatility tends to increase at important cyclical turning points. As you can see, over the past four months, the volatility in BHP’s share price has increased markedly, while the stock has essentially gone nowhere.
This is often a sign of distribution, a process whereby the early bulls sell out to the latecomers. This difference of opinion causes a lot of volatility for not much overall share price movement.
The fact that the share price tried to break higher in July but failed adds to the concern. That’s why $32 will be such an important area to keep an eye on. A break below there will suggest BHP is heading lower.
Obviously, the concern is China. As you can see, its stock market has had a horrid 2018. It recently fell back to the lows from early 2016, giving up all the bull market gains.
But so far, prices are holding at the lows. To the extent that the Shanghai stock market provides clues on the state of the Chinese economy (hard to tell in a centrally planned economy) it may be as bad as it gets.
The issue for BHP and its mate Rio Tinto Ltd [ASX:RIO], which last week traded at its lowest level since December, is whether China’s infrastructure led growth will continue to slow. That’s what their share prices are saying, anyway.
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As is another China barometer, Caterpillar Inc [NYSE:CAT]. As the chart below shows, it broke below support in June, then tried to recover, before falling again. That chart tells you that China’s infrastructure led growth is now on the wane. I’m not saying China is about to collapse. Rather, there are better ways to play China’s secular growth story.
My colleague Ryan Dinse has put together a report, ‘Pink Gold’, that gives you a different way to benefit from China’s growth. In short, there is more to the China story than exports of iron ore, copper and coal.
And in many cases, this new generation of exports are high value added, meaning they are much more valuable to Australia.
I urge you to read the report. Click here for details.
Editor, Crisis & Opportunity