There's safety in size

Just about all the recent financial press I have read in Australia has been bullish. Nobody can see a catalyst for an end, even a temporary end, to the equity market party we are all currently attending.

It seems that every commentator comes to the same conclusion. They all cite "liquidity" as being supportive of the market. Interestingly, nobody seems to describe the market as "cheap" on valuation metrics, but they all point out that liquidity conditions are highly supportive.

The part that most strategists miss is that liquidity conditions can change very rapidly. If everyone is of the belief that the market is supported by "liquidity", then the market is trading on a false premise, that liquidity will always be there supporting the market. It's a false premise that leads to broader expansion of price/earnings (P/E) multiples to reflect the lower perceived risk.

One thing I do understand is liquidity. From my first job in the futures trading pit I have been exposed to liquidity. It's what I know best, and I have learned not to trust liquidity. In all honestly, I have a better feel for liquidity than valuation, and that's where I can add value over other strategists who push a desk and aren't exposed to liquidity on a daily basis.

I am convinced from watching the deteriorating breadth in the market that the broader market is heading for a trading correction. I believe far too many people are putting faith in the liquidity argument, feeling any investing mistakes they make will be reduced by excess liquidity underpinning the market.

I also feel that many institutional investors are holding overvalued industrial stocks, afraid to sell them in case they might go higher, and that they have a broader fear of being underinvested in a rising market. I cannot remember a period where institutional investors were so scared to sell anything, and that's despite the index being at record highs. I can also never remember a period where hedge funds were so scared to short anything.

I very rarely get out the bear suit, or as I like to call it, the "Chicken Little" suit, but right now there is broad complacency behind pricing in parts of the Australian market and, quite frankly, too many people believe in the "Goldilocks" scenario. If only investing was so simple and so "risk-free".

The clear lesson last year was the market did NOT advance in a straight line. I hate using the "rear-view mirror" to explain forward-looking strategy, but it's worth reminding readers of the heavy volatility last year. Sure, the ASX 200 ended the year up 20%, but people forget that at one stage mid-way through the year it was down year-on-year. To believe this type of volatility won't exist in 2007 would be foolhardy, in my opinion.

I genuinely believe that most investors think this sort of volatility, even at the index level, is last year’s story. They believe "liquidity" makes this a one-way bet, but as you can see from the chart above, the market got on to the liquidity effect on stock prices from around October last year when Kohlberg Kravis Roberts made a move on Coles Myer.

The market is already discounting '” in fact overly-discounting '” this liquidity effect. Liquidity has just driven the ASX 200 up 1000 points off its lows, and the liquidity argument is already priced in. In my view, the real risk is that people are putting too much faith in the liquidity-support argument.

When liquidity support is strong and valuation support is weak you should be taking profits. The market is giving you a chance to sell some overpriced stocks, and prudent portfolio management says you should be taking advantage of this situation. As the great Jimmy Goldsmith said: "When you see a bandwagon, it's too late."

There's one last aspect of liquidity I want to again remind you of. I said it last week, and I'll say it again today: the way the market now takes profits is different. Nobody sells into strength. Everyone sells into weakness. Momentum investing is the dominant investing style, and it is changing the way the market trades.

Everyone from traders through to hedge funds and private clients seem to now use "rolling stop profits". They don't want to sell and see the share price rise further, so they now take profits into weakness once they know they have seen the top. They would rather sell 5% below the high and ensure they haven't left further upside on the table.

What I am saying is that when momentum does turn negative, albeit for short period, the pent-up profit-taking that will be done will be violent. This will not be an orderly trading correction. This will be sharp, and relatively painful as momentum investors all try to squeeze out through a small door.

I want to remind you of the Rinker example last year. Rinker was the king of momentum stocks. Momentum investors were all over the register and every analyst loved it. There was an analyst competition to see who could have the highest earnings estimates and price target. However, when sentiment turned, the share price moved into freefall. Momentum sellers all went looking for value buyers, but they only saw value 30% lower. Those momentum sellers eventually found those value buyers, but it wasn't pretty.

This is a key trading point. The price differential between what a momentum investor and a value investor will pay for a given stock can be as large as 50%.

Zinifex took over Rinker's title as the number one "momentum" stock. The stock has been bought as a leveraged future over the zinc price, yet in my view that game is up. This whole Zinifex situation has similarities to the Rinker example. Every analyst loves Zinifex, and even as the stock price corrects (due to the zinc price falling 30%), they all reinforce their positive views. They are all in the process of cutting their overly optimistic forecasts, yet they come to the conclusion the stock is cheap because the prospective P/E is six times and the dividend yield 12%.

Well, the P/E is six times and the yield 12% because the earnings and dividends are unsustainable. Consensus zinc price forecasts are 30% too high. The mine life is short, and the company lacks production growth to offset falling zinc prices. I have spoken to value investors about where they would consider buying Zinifex, and most say to me "around $8" (it opened trading today at $16.83).

You may think that's ridiculous, but you need to understand the "real risk" in owning stocks. If Zinifex falls out of favour with momentum investors, which I think it will as the upgrade cycle is turning into a downgrade cycle, then you will need to know where the next marginal buyer of the stock is. That marginal buyer is at levels 50% below today's share price.

There are times to play "hot potato" and "pass the parcel", and those trading strategies have worked very well over the past three years. Yet, in all these games you need to know someone is sitting next to you so you can offload the parcel. Don't be the investor who looks to his right and sees a cliff.

Our core strategy remains to rotate away from risk and leverage to large-cap, high-quality, high return on equity, high barrier to entry, world-leading companies, that are demonstrating capital discipline via either large-scale buybacks or valued added acquisitions. To put it bluntly, the strategy is out of crap and into quality.

The power of capital management surprise

Capital management surprises have been the clear spur to share price reratings in the interim reporting season. I believe "capital management surprise" is having a larger immediate effect that "earnings surprise".

The chart below, of BHP Billiton vs Rio Tinto, uses a common base as the benchmark since Rio reported on February 1. Rio delivered "capital management disappointment" at their full-year result, while BHP clearly delivered "capital management surprise". The chart tells you what the market is rewarding.

I can understand why capital management surprise is leading to instant reratings. We have an index at record highs, and value is broadly hard to find. The only value you can find is relative value. Institutional investors are nervous, and any company that shows nervous investors they are committed to large-scale, ongoing, capital management becomes a place of relative investing safety. Those who don't, while having the balance sheet capacity to embark on large-scale capital management, leave themselves open to speculation about what they are going to do with their under-geared balance sheets.

Being the rumoured acquirer of assets, unless you're a property trust, leads to underperformance. Property trusts apparently have the magic formula, but I doubt that will prove to be an accurate comment in the longer term.

As you know, from a purely trading perspective I too am trying to be a fraction less "gung ho". I too am struggling to find absolute value, particularly in industrials, and the industrials I want to park in for the next three to six months are generally large-caps that are actively returning capital to investors via dividends, capital management, or preferably both.

If we do run into shorter-term index headwinds driven by some long-overdue profit-taking, then at least parking in active capital managers will give a degree of comfort.

My core strategy, both from a trading and fundamental standpoint, is to keep to BIG, blue-chip, household names. Small and mid-caps are making a trading peak compared with their large-cap peers, and I want to be parked in the "boring" BIG end of the market. I particularly want to be parked in BIG cap laggards, such as Wesfarmers, BHP Billiton, Alumina, Woodside Petroleum, Santos, Coca-Cola Amatil, Lion Nathan, Boral, Rinker, Telstra, St George Bank and National Australia Bank.