Sentiment brightens, but the reality is bleaker

Buying at current prices may be more speculative than rational.

Summary: Economic factors such as the high dollar, the increased pressure on retailers, Australia’s growing balance of payments deficit, and a slowing in China’s growth, point to trouble ahead.
Key take-out: At current levels, there are a limited number of stocks trading at a discount to their intrinsic value.

Key beneficiaries: General investors. Category: Shares.

Last week’s year six father and son breakfast was never expected to raise any investment ideas. Indeed, I was so focused on the kids that I wasn’t even listening out for investment insights, when one hit me or, to be more accurate, brushed gently before me.

Speaking to a friend and semi-retired fund manager, who now spends all his time managing his own portfolio and cattle farm, he made the observation that everyone is sanguine, if not optimistic, about equities.

Who are you talking to? Everyone, he answered.

Holed up in our converted warehouse in Pyrmont, far from the distracting natter of daily broker lunches and street corner stock tips, I don’t get much of a handle on sentiment. Fortunately I don’t need to. Other than observing the stock presentations at the Macquarie conference that had one or two attendees (gold stocks) and those at which there was only standing room (commercial leasing stocks), my ‘reading’ of the level of optimism and pessimism is deliberately restricted to my observation of how many stocks are trading well above their estimated intrinsic value each day.

Either way, my experience is that the market always does what it needs to do to ensure the majority is proven wrong. And, based on the sentiment observed by my very experienced and successful friend, as well as the number of stocks trading at a discount to intrinsic value (none), it looks like the majority appear to be very “long” indeed. But is the enthusiasm misplaced?

The level of collapsing fashion houses (the Lisa Ho brand is the latest reported collapse) and retailers, as well as the number of local tourism operators and food producers doing it tough under the weight of the high Australian dollar, suggests there are few reasons to be overly enthusiastic about local economic conditions.

Long term, the issue for our country was laid bare by recent statements I noted between one local supermarket chain and a product supplier. The supermarkets are committed to delivering lower prices to consumers (beating the competition to it), no matter what the cost. They will import cheaper products from offshore if it means consumers can have cheaper goods than they are already getting. The problem with this strategy, of course, is that local manufacturers go bust and lay off staff, who in turn have to demand lower prices because they have lost their jobs.

We simply can’t demand local businesses deliver products and services at lower and lower prices while also demanding we get paid time-and-a-half, double-time and triple-time on weekends. Something has to give, and our policymakers’ addiction to ensuring lower prices will only deliver unemployment and serfdom.

Elsewhere, take a look at the balance of payments current account deficit and last night’s budget deficit. Not only would I suggest the business of Australia is in poor financial shape, but I might also suggest it has poor managers at the helm too. So why the investor enthusiasm?

Weaker international currencies are also making foreign exports more competitive than our own, while also fuelling their improving business and investment conditions at the expense of our own.

Observing several years of disengagement between the Australian and US stock markets and an increasing influence from the Chinese stock indices, one can see that it is not just the high level of iron ore and coal we export to China that ties us to that country’s fortunes.

Quite simply, what is going on in China should serve as a warning to Australian stockmarket and property speculators. The next five to 10 years in China will be nothing, repeat nothing, like the last decade. That country’s positive influence on Australia’s prospects may become proportionally negative and prove just as cyclical as the commodities we export to them.

China is moving from investment-led growth to consumption, but the transition may not be nearly as easy as that statement is to write. Meanwhile debt growth, the product of China’s own quantitative easing to fund increasingly unsustainable rates of economic growth, may be reaching its own limits, and economic growth must slow if household income is not built up fast enough to replace the contraction in government spending.

I personally think, as do an increasing number of others, that even 7% economic growth in China will not be achievable beyond this year, and the motivation for reaching it this year is merely the pride and reputation of the new leadership. More importantly for Australia, even if 7% is achieved it will not be as capital intensive as previous growth, so expect slower increases in demand for our iron ore at best.

On the supply side, Rio, BHP, Fortescue and Roy Hill will all add to iron ore production in the near term. The result? Falling prices. No wonder George Soros is rumoured to be shorting the Australian dollar. The rumours of me having done the same might also be correct.

If you are trying to pick the bottom in iron ore stocks, or worse justifying the purchase on yield, just remember you are speculating, not investing. Finally, given I cannot find many, if any, bargains in the stockmarket today, buying at today’s prices may also be more speculative than rational.


Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com