To Panic or Not To Panic about Financial Markets

Financial markets around the world were steady overnight as they continue to hover around record highs. The Aussie market is strongly bullish too, on expectations of more RBA interest rate juice coming through the pipeline.

For the first time in a long time, I’m seeing a large chunk of the smaller, less visible part of the market start to move higher. It’s not just the big banks or the other large dividend payers contributing to the markets gains…although that is where most of the investor focus still seems to be.

What’s causing this broader rise in the market? Who knows…interest rates are clearly the driving force, and the lower dollar must be having an impact too. But it’s not because investors think lower interest rates are going to magically boost the economy and company earnings.

Rather, the recent interest rate cut and expectations of more to come have simply sparked a big move of capital into the market. It’s anticipating a speculative melt-up as the world’s central bankers keep pressing the interest rate button in the vain hope that it improves ‘animal spirits’ or ‘confidence’.

You might think it is strange and perverse that the market can be so bullish, and bestow its ‘wealth’ on many people, at a time when the economy is the weakest it has been in many, many years.

But that’s what happens in a world dominated by central banks. For now, cheap money trumps all else. And while that is the case, it doesn’t pay to be overly bearish…not in the short term anyway.

Which is a difficult thing for me to say. Longer term, I am hugely bearish on the prospects for the global financial system. In the next few years, I think you’re going to see all sorts of problems as global debt levels completely engulf the productive capacity of national economies.

But for now, the market action is telling bears to get out of the way. The recent spike to new highs sends an important message. Here’s what I wrote to Sound Money. Sound Investments. subscribers about the issue:

So despite all the issues with the Aussie economy — a structural slowdown in China, weak commodity prices, record household debt levels, low business and consumer confidence, and a basket case political situation — the market just doesn’t care right now.

The market is saying that lower interest rates will, for the time being, offset all the economy’s other ills. Given the recent break to new highs, the balance of probabilities suggests this market will continue to go higher.

Whether you like it or not…whether you agree that stocks should become more expensive in such a moribund economy or not…that is what’s happening. The market is bullish, and so it’s time to look for good value stocks in emerging uptrends that offer good risk/reward trade-offs.

The good news is that I’m seeing a number of opportunities in the less popular parts of the market. That is, stocks that are showing good value and are in an emerging new uptrend. And there’s still the odd blue chip where you can find decent value. I just recommended one that has been off investors’ radars for a few years…but is now coming back into focus.

But the market is weaker today thanks to a sell-off in the banks. What could that be about? More on this in a moment.

First, take a look at the recent performance of BHP Billiton [ASX:BHP] to see how bullish market sentiment is right now. The chart below shows that since mid-January, BHP’s share price has surged by nearly 30%.

 

Are things all of a sudden better for the Big Australian? Or is it just a case of the bulls running over the bears for the time being? I suggest that it’s the latter.

Take this article from the smh.com.au:

BHP Billiton believes lower diesel prices and the weaker Australian dollar could deliver a bigger boost to its full-year financial results in August than the half-year results published this week.

The mining giant revealed a 29 per cent decline in the cost of producing iron ore in Australia over the six months to December 31, as cost-cutting combined with currency movements and lower diesel prices to reduce the damage caused by sliding iron ore prices.

The lower diesel prices delivered a $US233 million ($298 million) boost to the profit line, BHP’s financial statements show.

Hang on a minute…

Diesel prices fell in the half because oil prices fell. BHP is a massive producer of oil. So where some of its operations benefit from lower input costs because of lower energy prices, the oil division’s losses more than makes up for it. Talk about glass half full!

And keep in mind that the pace of the oil price decline only really picked up in November and December last year, meaning the oil division only really suffered for two of the four months in the half. If oil prices don’t pick up quickly, it’s going to be a tough full year for BHP’s oil earnings.

It’s true though that a falling Aussie dollar is helping over at the iron ore operations. Lower costs are helping to offset the sharp fall in the iron ore price. But this is the very thing that will continue to put pressure on iron ore prices for the next few years at least.

As BHP (and RIO) continue to lower costs and churn out ever greater quantities of iron ore, it puts pressure on the price. This will eventually wipe out the marginal producers who just can’t compete on the cost front.

The question is how far will the iron ore price drop? So far, the price weakness reflects the big supply increase. But demand, if steel output in China is anything to go by, has at least held at high levels.

There is a huge amount of excess steel capacity in China and mills produce more than is really needed. If China decides to enforce structural changes to its steel industry, then the iron ore price could head down into the US$40-50/tonne range. The risk to prices is clearly to the downside.

Yet the market prices BHP on 16 and 16.5 times earnings over the next two years. This is expensive for a resources company and tells you the market expects an earnings recovery in the years ahead.

A recovery from what though? The biggest commodity boom in Australia’s history? Iron ore may have peaked back in 2011 and fallen over 60% from its peak, but it was a massive bubble. Bubbles can deflate 80-90% before prices start to recover.

Iron ore is still in a downtrend, and BHP is too. Don’t fight it!

The banks though are all in strong uptrends. But today they’re not so popular, with most of the big four off by about 0.7% as I write.

I’m guessing that the government’s proposed changes to rules over foreign ownership of Australian property might be having an impact.

Yesterday, Treasurer Joe Hockey announced that foreign buyers of property would pay an additional fee of $5,000 for any purchase under $1 million and $10,000 for a purchase between $1-2 million, with higher charges the more expensive the property is.

My initial reaction was ‘big deal’. This is such a tiny sum it won’t do anything. And the fact that the government expects to raise $200 million from the charges tells you that it still sees plenty of transactions going ahead (i.e. no discouragement!).

Is it a cash grab or is it genuinely trying to ensure that Australian homeowners are not priced out of the market?

The answer is that it’s a cash grab. Housing speculators (sometimes referred to as investors) are doing far more to price genuine homeowners out of the market than foreign buyers. But foreigners are a much easier target than, say, making changes to capital gains tax allowances or negative gearing rules.

But I’m also encouraged by one thing. That is, the real estate industry is up in arms about it. That’s a good sign. Yet one industry spokesman, who I heard on Radio National this morning, argued that foreign buying is a tiny portion of the market and doesn’t make a difference to house prices!

This is fun…watching Australia’s most coddled industry panic (or not panic) about changes that may or may not do anything to the real estate market. The naked self-interest is breathtaking. Clearly foreign buyers are great for business for some…and don’t matter to others.

I’ll enjoy seeing how this plays out in the weeks ahead. I hope you do too.

Until tomorrow…

Greg Canavan,
for Markets and Money

 

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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