Research Watch

The market’s new risk disconnect. Is China heading for a hard landing after all? Opening the exit door for Greece. Can gold reach $US3000 an ounce. On video, Nouriel Roubini on China.

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

The ASX's recent rally has surprised more than bears. Bond investors, too, have been scratching their heads as yields stagnate, creating a strange new risk disconnect in markets that has now gone global; find out why below. It might not matter much longer, though, because UBS says a dismal reporting season could turn the Australian market around. Goldman disagrees. Elsewhere, positive signs in China have reduced the risk of a hard landing, as an even closer trading partner is named frontier market of the year. Stock pickers can re-enter the market after the latest correlation figures, and Citi says Greece can exit the eurozone without too much of a fuss. Dave Rosenberg sees gold at $US3000, but Warren Buffett explains why he prefers businesses over bullion in a sneak peek at his next shareholder letter. Meanwhile, the ultimate contrarian indicator screams “sell everything!”; while, on video, Dr Doom on China.

What's behind Australia's great market disconnect '¦

“The green line is the Australian All Ordinaries index and the orange line is the yield on the Aussie 10-year bonds '¦ It's weird because you'd think that as stocks rose – indicating increased risk appetite and expectations of growth – that yields would rise too, since demand for risk-free instruments would wane. But that hasn't happened. Stocks have had a really nice run but yields have gone nowhere. In a recent note, Credit Suisse '¦ listed this as [the] top anomaly in the market right now. But one thing you'll notice is that to a varying degree, this is a global phenomenon [especially apparent since December; click through the link below for similar graphs of the US, Sweden, Germany and Japan] '¦ One thing that all these countries have in common is their borrowing is done in their home currencies, meaning they're essentially risk-free except from a currency perspective. A decent theory is that despite the big pickup in optimism, there's still a shortage of vehicles available to investors looking for 'risk-free' assets. So the countries that can offer these bonds are still seeing unusually high demand.” (Business Insider, April 7)

The ASX's New Normal '¦ UBS is predicting a further slowdown in aggregate earnings growth and a continuation of the dual-speed economy. [They have revised down expectations for every sector except energy and utilities, which is] suggestive of the general gloom in the market. But how much of the weakness has been factored into prices? '¦ From UBS: 'It is often tempting (particularly for value managers) as we approach the reporting season to buy stocks that appear too cheap. However, given the correlation between earnings and multiples, retractions in earnings often lead to greater than expected retraction in prices. As a consequence, it is important when buying value prior to [a company's reporting date] to ensure that the prices are underpinned by earnings.' UBS is arguing for a big shift towards dividend income, which is hardly a startling conclusion but welcome given the slowness with which the broking community has realised that the glory days are over: 'In a world of slow growth, income makes up a larger proportion of total returns. During the previous delevering phase of 1929 to 1945, the Australian market delivered an average annual price appreciation of 3.2% pa and a total return of 9.3%. In other words, 6.1% or about two-thirds of the total return came from dividends. Almost half the market pays a fully franked dividend (92 companies within the ASX 200) and a further 22 pay a partly franked dividend. With a dividend yield of 4.9% and an average level of franking across the market of 71%, the market is currently paying 148 basis points in franking alone. As a consequence, focusing on companies with fully franked dividends provides investors with a free kick.'" (UBS via Macro Business, February 2)

But Goldman Sachs sees considerable upside ... "Goldman Sachs boosted its targets for the S&P/ASX 200 after upgrading global-growth forecasts in the light of improving macro-economic data. 'In light of these macro changes, we have reviewed the key assumptions driving our market targets for 2012, in particular prospective multiples, which had assumed little change to the investment sentiment for the first half of 2012.' The broker has increased its June 2012 forecast by 5.9% to 4340, while also raising its December 2012 forecast by 2.2% to 4500. It says the current forecast price/earnings (P/E) multiple for S&P/ASX 200 Industrials including Financials, of 11.5 times, compares to the 10-year average of 14.3 and the long-run average ... Furthermore, Goldman Sachs notes that there is 'considerable upside for equity markets if P/E multiples revert faster than our current expectations; for example, a prospective P/E multiple of 13 times by December 2012 would generate a target of 4880.' (Dow Jones, February 8)

Stress relief in China '¦ “Remember Nomura last year estimated there was a one in three chance of a hard landing in China? Anyway, they’ve updated the index on which it was based. Nomura’s chief Asia economist, Rob Subbaraman, says the one in three odds indicated by the China Stress Index (CSI) remain, but the hard landing is less likely:

From Nomura: 'In June 2011, the CSI rose to its highest level since it was first compiled, but in Q3 it eased, and our latest update shows that it eased slightly further in Q4. The main reasons for the CSI falling are highlighted in the second part of the graph. Overall, the unwillingness to ease macro policies aggressively despite slowing GDP growth seems to be starting to pay dividends in lessening longer-term macro risks. However, it is still early days and policy errors cannot be ruled out amid still-large macro imbalances and high global uncertainty. We retain our one-in-three likelihood of a hard economic landing commencing before the end of 2014, but now have a bias to think it less likely.'” (Nomura via FT Alphaville, February 6)

The best frontier markets for investors ...

(Bloomberg Markets Magazine, February 7)

Welcome back, stock pickers '¦ "From our perspective, portfolio tracking error for most money managers has been relatively low over the past several years and understandably so since high stock correlations virtually eliminated the reward for having more aggressive portfolio positions. However, 2012 has been an entirely different story as correlations have fallen dramatically with current levels near their lowest levels in over the past 25 years. This is particularly interesting considering January’s strong market performance, which implies that while some stocks had very strong gains, others had very weak gains – a sharp divergence from performance patterns exhibited toward the end of 2011 '¦ Since we believe that current stock correlation trends are likely to persist throughout the year, it is important for investors to place additional emphasis on active investment strategies." (Oppenheimer via Money Game, February 6)

NOW SELL EVERYTHING! '¦ "Hedge fund manager and writer Doug Kass just sent out a blast titled 'SELL EVERYTHING'. Why? Because Nouriel Roubini is bullish. You read that right, the perennially negative Roubini – nicknamed Dr Doom – is betting on additional stockmarket gains. 'We’re a believer; we’re celebrating. We think the rally has legs,' explains Gina Sanchez, Roubini’s director of equity and allocation strategy. You have been warned." (Business Insider, February 7)

Gold to $US3000 '¦ “Indeed, the yellow metal is trading less and less like a commodity over time and more like a currency – a currency that is no government’s liability and where no central bank has a printing press. The Bank of Japan just announced how it has been engaging in 'stealth intervention’ to weaken the yen. The Europeans desperately need a soft euro to have exports act as an antidote from escalating fiscal drag. Of course, we saw the Swiss last year throw in the towel on accepting a strong franc. In the emerging markets world, there has been no shortage of market-meddling initiatives to soften their currencies. And in the US, part of the White House drive to bring jobs home – how mercantilist can this be? – necessarily involves sanctioning a 'more competitive’ currency. Now we have central banks continuously priming the monetary pumps as well. If we adhere to Bob Farrell’s Rule #1, [that markets tend to return to the mean over time,] and then look at what that is going to mean with respect to the ratio of gold price to global currency in circulation, getting to $US3000 before the bull market in bullion busts is, in our opinion, quite easily attainable.” (David Rosenberg via Pragmatic Capitalism, February 8)

But Buffett prefers companies ... "Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet (20.7m) per side. (Picture it fitting comfortably within a baseball infield.) At $US1750 an ounce – gold's price as I write this – its value would be about $9.6 trillion. Call this cube pile A. Let's now create a pile B costing an equal amount. For that, we could buy all US cropland (400 million acres – 162m ha – with output of about $US200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $US40 billion annually). After these purchases, we would have about $US1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $US9.6 trillion selecting pile A over pile B? ... A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops -- and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond." (Warren Buffett in Fortune, February 9)

'Grexit' signs '¦ "Grexit being, of course, a Greek exit from the eurozone. The term comes from Willem Buiter and Ebrahim Rahbari at Citi: 'We raise our estimate of the likelihood of Greek exit from the eurozone (or 'Grexit’) to 50% over the next 18 months from earlier estimates of ours which put it at 25-30%. Second, we argue that the implications of Grexit for the rest of the EA and the world would be negative, but moderate, as exit fear contagion would likely be contained by policy action, notably from the ECB.' '¦ Notwithstanding support from the ECB, Buiter and Rahbari also reckon that European banks have now mostly insulated themselves from Greece and have offloaded exposure in the past 18 months. Some of the Citi comment on Greece’s economic fate post-exit is pretty chilling in its clinical tone: 'For most other countries in the euro area, a Greek import collapse would seem to be a manageable inconvenience,’ for example. Buiter and Rahbari even argue that leaving the euro '¦ would be a 'cathartic experience’ for reforming the Greek state." (FT Alphaville, February 7)

Hedge funds, s-x and video tapes '¦ "A hedge fund manager [Chris Hsu] claims he was kidnapped and assaulted for eight hours by former Miss Korea 1995 and her family '¦ The hedge funder has filed a lawsuit against Han Sung-Ju, a former beauty queen who is now a television personality, alleging that he was locked in a room by her brother, mother, and two other men where he was assaulted for eight hours '¦ In his suit, Hsu also alleges that his ex-girlfriend used his credit cards to buy an Hermes watch and an expensive handbag among other luxury items racking up a bill of 340 million won '¦ Sung-Ju's lawyers denied Hsu's allegations of assault '¦ Prior to filing the lawsuit, it appears that Hsu struck first '¦ by making public a thee-minute sexual tape of Sung-Ju." (Clusterstock, February 6)

Video of the Week: Roubini on China '¦ Dr Doom discusses hard landings and leadership change with Patrick Chovanec, associate professor at Tsinghua University's School of Economics and Management in Beijing.

(The EconoMonitor, February 8)

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