The Seatbelt Sign Will Be Turned Off Shortly

The market is always trying to test you. Just when you think it’s easy and that the market is a money-making printing press, it wakes you from your reverie with a quick jab across the chops. Yet the jab is just to see whether you’re still awake; it’s not a knockout blow.

I do think the current volatility is being exacerbated by school, and religious holidays. Many senior portfolio managers are away, and you usually find that their deputies don’t want to do much while the boss is gone. That leads to days like yesterday, the market’s worst in three years, yet nobody stands up to be counted.

The game is to stay focused, and use this volatility as the clear opportunity it is. Use it as an opportunity to buy high quality, long-duration cyclicals and the beneficiaries of falling oil prices. Use it as a selling opportunity in stocks that are bond-sensitive for valuation, as they have the biggest long-term risk of de-rating.

Bond yields are going up and owning too many stocks that are directly valued by long bond yields is a mistake. Own the companies that, via their own "pricing power", are bringing "inflationary pressures" to the world, not the losers of those pressures. The three sectors we continue to recommend profit-taking in are infrastructure, listed property trusts and energy.

Once we get the traditional October nervousness out of the way, and the weak and hot money out of the market, we will be set for a good run into Christmas as the AGM season reaffirms the solid outlook for corporate Australia. Close your eyes, and buy the trading dip.

Think of it this way: the stockmarket is like a big, shiny jumbo jet on a long-haul flight. It has made a steady climb to cruising altitude and has encountered a little "clear air turbulence". Sure, it’s uncomfortable, but certainly not bad enough to bring the plane down or force it to land short of its destination; but many of the passengers will find the experience unsettling enough to put them off flying for a while

We seem to hit these "clear air turbulence" periods when there is a complete lack of company-specific news. We are in the lull between last financial year’s reporting season and the current year’s AGM season. Just about the only news around is macroeconomic. Suddenly, the Australian market finds itself completely at the whim of global macroeconomic developments, or even suspected global macroeconomic developments.

I find it amazing the world is now worried about the impact of high oil prices, when it’s clear that prices for the benchmark West Texas Intermediate oil have peaked at $US62.79.

The thing about turbulence is that it is usually short-lived. It can be a little violent, yet the flight usually continues on its intended course. The All Ordinaries index has shed 140 points over two days '” a "correction" that made for dramatic headlines; but it has merely returned to its level of just 20 days ago.

All we are seeing is the end-of-quarter gains being eroded, and clearly we are seeing some very "hot" money exit the market. Interestingly, and unsurprisingly, the profit-taking has been most aggressive in stocks that have led the rally or in stocks that have recently had capital raisings.

Who caused this correction? Was it me calling for a "Christmas rally" earlier this week, or was it Scottie Calcraft at Morgan Stanley buying a Mercedes-Benz? Perhaps it was a combination of both.

I am confident this "turbulence" is a medium-term buying opportunity in quality, as it is quality that will be hit hardest in profit-taking bouts. However, for the final quarter of the year I believe those stocks that have been "under-performers" for the first nine months of 2005 will turn out to be the "out-performers”, as the long-repressed beneficiaries of lower oil prices stage a "relief rally".

I also believe the Australian economy is in very good shape, with GDP re-accelerating, albeit with different drivers of growth. I also believe that domestic interest rates are going nowhere in the short term, and don’t foresee the RBA raising rates until at least March next year. Similarly, I believe the listed and unlisted corporate sectors are in unprecedented financial health, particularly on measures of interest cover and net debt to equity. Moreover, it appears the Reserve Bank shares my view

Consumers are spending their money on "household goods" and "recreation", and that is not going to change any time soon. Although overall retail sales growth has slowed as the "home equity ATM" has been turned off, the clear point is that retail sales are still growing, driven by full employment, stable interest rates and rising wages.

"Aspirational Australia" is a hard worker, with a new entrepreneurial attitude. Yet for his hard work he wants the trappings of a better life: a new car, an overseas holiday, renovations and the latest and greatest electrical goods. It’s apparently all about "status symbols" and showing your neighbours that you are doing well in life.

For the best part of this year, Australian discretionary retailers have under-performed the broader market because of consumer concerns about rising petrol prices, falling property values and more aggressive discounting by marginal discretionary competitors. However, when you look at recent data from the RBA, retail is a sector of consistent growth in Australia so we must have some exposure to it.

I think the best way to play Australian retail is via the category killers. If you own category killers such as Woolworth’s, Harvey Norman, David Jones and Bunnings, you take some of the cyclicality out of your investments. Category killers in the US, such as Wal-Mart, Best Buy, and Home Depot have been out-performers for a long time, somewhat impervious to short-term economic cycles. Australia doesn’t have the population or breadth of markets to take out all cyclicality from retailing, but I get the feeling that the Australian category killers are going for the kill during this tougher trading period.

I understand from retail industry contacts that the leaders of these sectors are flexing their muscles, pushing their purchasing power advantage hard, and attempting to drive overall retail margins up in a tougher volume growth environment. I also believe technology is adding significantly to margin lift, with new-generation inventory and sales management systems finding their way into the category killers. Radio frequency identification tags on pallets (Brambles), new bar-coding technologies, and partnerships with leading transport/logistics companies (Toll/Fox) are also helping lift margins by cutting costs.

I believe the current high petrol prices are hitting "low-end" retailers much harder than the middle and high-end. That makes textbook economic sense, as high petrol prices are a "regressive" tax on growth. If you want to see this first hand, head to Westfield Bondi Junction.

There, a David Jones store is one level above a Target store. Last weekend I couldn’t believe how few people were in Target and how many were in DJs. The Target checkout was very slow, while people were queuing to pay upstairs.

Even though the prices at DJs are significantly higher for identical items, such as toys, I saw shoppers pay the higher price for the item at DJs. That’s a very nice demographic advantage to be utilising as a retailer, where people buy from you even though the price you are charging is higher than your competitor downstairs.

Harvey Norman also has this "category killer" style, which is demographically driven, and offers a pricing and margin advantage. Harvey Norman also has the ability to "up sell", thanks to a wide range of products, accessories and warranty options. Another advantage over small rivals is its well-entrenched "interest-free" financing arrangements.

I spent three hours at Harvey Norman yesterday, at the flagship Domayne store in Alexandria. (I was even shown the "spa testing room" for couples!) Many analysts believe Harvey Norman management has lost its edge, pointing to flatter same-store sales growth, but I think these guys are more on the ball than ever. They’re working on margin expansion, and selling convergent technology in new formats.

They are totally on top of their game, particularly director John Slack-Smith, and more aggressive and interested than the market gives them credit for. I also believe the market has prematurely given up on new stores being added to the chain, naively believing there simply aren’t enough sites available for new "big box" retailing centres.

There are plenty of sites; they’re just in the wrong hands at the moment. During the retail boom of 2003, property speculators and listed property trusts bought anything that resembled a potential big box retail site. Their problem now is that if Bunnings or Harvey Norman won’t commit to the development as a cornerstone tenant, lenders are not interested.

These sites are now starting to burn holes in the developers’ pockets, and I wouldn’t be surprised to see Harvey Norman, Bunnings or the like do some very favourable land deals in the next 12 months. When that happens, the market will start given some credit to both companies new store roll-out ambitions.

Independent retailing contacts tell me that the category killers are gaining market share from independents. So, while overall retail sales growth has slowed, the category killers are taking a bigger share of the market. For example, it’s believed that Harvey Norman now accounts for half of Australia’s laptop computer sales.

This is a very interesting development, and positions the category killers even better for a retail sales growth recovery when it comes (after income tax reform). The current price/earnings multiples of the category killers don’t reflect these market share gains, they simply reflect current tough retail trading conditions.

My retail contacts all believe the opening of the M7 Western Orbital in 2006 will be a positive for Sydney Basin retailing. The road will reduce transit times through Sydney’s busy western suburbs and should increase customer flow to "destination" shopping centres. That means stronger sales for category killers, which are generally located in these centres.

In a broader stockmarket, it’s difficult to find absolute franchise value and bottom-of-the-cycle earnings, so investors should look at the category killer retailers. The two cheap large-cap bottom-of-the-cycle stocks are Wesfarmers (WES) '” which owns Bunnings and Harvey Norman (HVN), while the cheap large-cap "cycle-proof" stock remains Woolworths (WOW). I think WOW is cheap given its unbelievable footprint and growth prospects. WOW is clearly Australia’s Wal-Mart.

Anyone looking for value and potential recovery earnings leverage in 2006 '” particularly in the current volatile environment; could do a lot worse than pick up a few of these category killers while they are on "special".