Break Out the Market Umbrella

Investing is more about confidence than anything else. I am not referring to the state of mind of individual investors making decisions on a regular basis, but to the common denominator of all individuals '” what we tend to describe as "the market”.

Sports fans among the readers of this weekly analysis will have no problem in understanding what I am talking about this week. It happens in rugby matches every weekend across the country. If the confidence of the team is strong enough it doesn't matter whether the opposition is leading by two tries. A confident team simply falls back on its talent and battles back, often reversing the situation from a potential loss into a breathtaking win.

If the team's confidence starts faltering, however, there's no way to predict how big the thrashing will turn out to be.

The same principle applies to financial markets. At times when everybody seems to be enjoying the sun, few will pay attention to the clouds forming on the horizon. Even when the sky turns grey-ish and clouds have multiplied, you will still see people getting ready for a dip in the warm sea. If you watch closely you will see some are putting on extra sunscreen while the locals have already gathered up their clothes and are leaving the beach. When clouds break and rain starts pouring, you'll often see chaos and panic.

Why is it not everyone draws the inevitable conclusion at the same time? It's one of those mysteries that makes investing as predictable and as unpredictable as it is.

Stockmarkets in the US and Australia have been powering along over the past few months and most commodities have seen price hikes that were regarded as impossible only six months ago. At the same time, for those who were experienced and savvy enough, signs had been emerging there would be rain at some stage.

Global interest rates are going up, not only in Europe and Japan, but throughout Asia and China as well, possibly still even in the US. This is not really a new given, but a confident "market" simply refused to pay attention. Did anyone pay attention? Well, some of the smarter guys had already started to roll up their towels and silently leave the beach. From US equities to base metals to gold, reports were signalling the so-called smart money was pulling out and watching events from the sidelines.

Renowned US-based trading advisor Dennis Gartman pulled half of his money out of the US equities market on Wednesday last week. He put close "stops" under the rest of his positions.

UBS metals experts reported some of the more experienced traders in gold were no longer holding positions. And Merrill Lynch reported global risk appetite, while still at an elevated level, was showing signs of breaking down. The broker's so-called "global cyclical indicators" have now moved to risk aversion so don't be surprised if the likes of State Street, Credit Suisse, Dresdner Kleinwort Benson and even Tolhurst Noall '” all of which are known for recording that same elusive "risk appetite" among investors '” start reporting a loss of investor "confidence" over the next few weeks.

Citigroup economists have been among the first to start scaling back their global growth expectations. There is nothing alarming in this as the changes are minimal, with plenty of room for commodities demand to still underpin the long-term bull cycle, but as global sentiment has started to deteriorate, and more economists are likely to follow suit, this might well become the next focus of market attention.

As we all know from personal experience, when you are in a not so positive mood all it takes is a few negative signs to start fearing the worst. Right now the "market" is growing concerned about high prices of commodities and energy pushing up global inflation. This will force global interest rates up, dampen economic growth and devalue assets such as listed shares.

Soon, no doubt, public concern about a freefall in the US dollar will add to the inflation fears. Few are holding up their hands when it comes to supporting the US dollar in the near term. Although everyone seems to agree that a weaker US currency is necessary to help address global imbalances and reduce the US current account deficits, the currency will need a sufficient amount of supporters in the market to achieve this in an orderly fashion.

Nobody wants chaos '” chaos is bad in finance '” but nobody seems to be prepared to support the US dollar either. Several smaller central banks have already scaled back their US dollar holdings. Will the rest follow suit? Russia wants to be paid in euros for its oil deliveries. Will the Arab countries switch as well?

Predicting market corrections is far from an exact science and many a market commentator has eaten humble pie during the past four years.

The FN Arena Market Sentiment Indicator, which is based upon the relative amount of neutral recommendations among Australia's leading equity brokers and advisers, is a useful barometer. When it's high, the omens are good for stockmarkets; when it’s low the outlook is bad.

So far this decade it has ranged as high at 59% in the dull days of 2002 when everything was a “buy” (but nobody was investing) to as low as 50% prior to the sharp, but short decline the market experienced in mid-2005. Two weeks ago the indicator hit 50.3%

After that it briefly climbed above 52% again last week, then fell below the magic 51% barrier. Shares started to weaken soon after.

The amount of neutral recommendations made a leap towards the 53% at first in recent days, but it has swiftly returned to near 51% again. If the trend continues we will soon see it dropping to less 51% again. Expect more share price weakness in the short term. The indicator hasn't failed once during the past four years.

HIGHLIGHT STOCKS

DCA Group (DVC): Lesson one in the dos and don’ts when you're managing a publicly listed company: never, ever, try to bury a profit warning at the bottom of a press release. It still beats me why directors think this is the best way to deliver the bad news. The latest one to experience the harsh lessons of being a public company is healthcare provider DCA Group. A few weeks ago, DCA was among the most highly recommended stocks in the Australian stockmarket. It has now fallen close to the bottom, with recommendation downgrades still kicking in. Even potential lucrative tender wins in Britain won't compensate for the damage done by management's latest action. To make it even worse, some analysts are now questioning management's trustworthiness and market credibility '” a suitable punishment for such a ridiculous way of trying to hide the fact that things have not turned out as rosy as previously thought. Investors don't like getting their fingers burnt, so don't expect a bounce back anytime soon, despite the likes of ABN-Amro and Intersuisse maintaining a positive recommendation for the shares.

Incitec Pivot (IPL): Orica's announcement that it would sell its stake in fertiliser company Incitec Pivot put IPL shares firmly under the market's attention this week. The average share price target surged to $22.98 from $19.83 in one swift movement, while the shares' reading on the Market Sentiment Indicator improved to 0.7 from 0.2 in one week. It's not just about Orica's shares landing on the market, Incitec's businesses have started to perform significantly better in the recent past, but nobody had paid much attention to it yet. Until last week.

Rinker Group (RIN): According to an American blog service, Warren Buffett may be looking at investing in Rinker Group. Given the highly speculative nature of the announcement, it would seem rather unlikely this will further improve the company's rating in the Australian market. Despite an outstanding share price performance over the past few years, Rinker remains among the most highly recommended shares in the Australian market, although the average price target has come off a bit recently.

National Australia Bank (NAB): Australian banks have had a dream run over the past few months, clearly outperforming the broader market supported by a relentless bull market in commodities. But sentiment seems to be turning against them, with leading brokerages such as UBS scaling back their sector rating. National is the worst rated of all the majors. Management is doing a great job turning the mogul around, but its the relative valuation of the shares that keeps most experts on a negative note.
Telecom New Zealand (TEL): The telecommunications industry has landed in a negative spiral, but not everyone is equally convinced. Brokers such as Citigroup have rushed to support Telecom NZ this week, claiming things are not looking as badly as the market has started to price in. Investors had better remain cautious because Telecom NZ was still highly rated as recently as a few weeks ago and we should all know a negative spiral often brings out more negative events. Telstra and iiNet have felt the weight of market scepticism as well. It’s a brave investor who puts many of their nest eggs in telecoms these days.