Warning Signs are Flashing

Equity market investors seem to be ignoring the headline inflation number and concentrating on the core inflation figure, which excludes food prices and petrol. This is fine for the Reserve Bank because it has to exclude short-term volatility in setting medium-term policy. However, if you are Joe Average, unless you don't plan on eating, or driving a car anytime soon, you are going to cutback on consumer spending.

The Producer Price Index is telling you that inflation will be a problem in the future, but in the first quarter it is being absorbed by robust company margins, or perhaps industrial margins won't be as strong as analysts expect in the 2005-06 reporting season. The gold price ($650 an ounce) is telling you core CPI inflation is going to be a problem in the future. It is also the ultimate contrarian indicator, at the exclusion of all other asset classes.

It's worth remembering the first quarter inflation numbers were set off significantly lower commodity prices than we are experiencing today. Average commodity prices for the second quarter are 20–30% above those of the previous three months, and I believe you will see some real inflationary pressure in the second quarter CPI numbers. I'm getting plenty of anecdotal evidence of rising inflationary pressures, including everything from "zinc surcharges" by steel companies, to "fuel surcharges" by transport companies. Residential rents are also rising, and rent is a large component of CPI. Perhaps we should look at “CPI ex surcharges"! Inflation is coming, readers, yet the Australian equity market isn't concerned. I think that's a mistake.

Will this lead to the RBA conducting a "pre-emptive monetary policy strike"? I believe there is a chance of that happening, but the problem in Australia is that bond yields are rising because of growing inflationary fears, not rising due to growth being stronger than expected.

I believe we are at a pivotal point for the equity market, where investors need to consider the broader ramifications of high energy prices, inflation, the Australian dollar and interest rates. Although the equity market has been focused on the "Goldilocks" scenario lately, the bond, bill and currency markets clearly have not.

THE STEPS ARE STEEPER

I've becoming increasing concerned about a pending trading correction. Bull markets "climb the walls of worry". The Australian equity market has been ascending an uninterrupted 1200 point staircase since September last year. Now the steps are getting steeper, and there are no hand rails. We are heading for the point of highest risk, where even the slightest mistake will have large ramifications.

I decided to start toning down my strategy a notch when the market reached 5248 index points. It has added about 70 points since then, with the breadth narrowing and the advance/decline line turning negative. So far I have been a fraction early in my caution, but with every passing day I become more concerned about a sharp trading correction.

The only reason investors give me for the market’s ongoing resilience is "weight of money", but I regard that as a very flimsy argument. The weight of money is always strongest at the top, and nowhere to be seen during the corrective phase.

I want to put on the record that I am genuinely concerned about the widespread investor apathy that has pervaded the Australian market. The equity market doesn't simply print you money every day. I believe there is a record amount of leveraged money in the market at the moment and I suspect there's a very big game of "pass the parcel" going on between highly leveraged investors. You simply don't want to be left holding the expensive parcel when the music stops.

Regular readers would know I am generally the most optimistic commentator in Australia, and it hurts me to even type a cautionary word. These are short-term concerns I have, but in a market that is pricing no risk at all, I smell trading trouble coming. You must realise that any trading correction won't be gentle. It will be violent, and may occur over four days. It will be classic "down by the elevator". Yet in four days you could easily wipe 400 points off the ASX200, and that would be a reminder to all those who believe we are operating in a risk-free environment here. I know this is not what you want to hear, but someone has to tell you.

There is no doubt in my mind that domestic investors, generally, have become very complacent on the positive outlook for domestic equities. The consensus view is one of contentment or smugness but, more importantly, investors remain largely unconcerned about the obvious warning lights flashing for equities. In my mind we have had three years of "green lights" for Australian equities, but I just feel the lights have turned "amber" and nobody is planning on stopping.

The last trading correction for the Australian equity market, in September last year, was prompted by a record high for the oil price at $US70.85 a barrel, and domestic petrol prices reaching $1.30 a litre. The result was a sharp fall in consumer sentiment, a slowdown in consumer spending, and a correction for industrials, particularly retailers, transport, manufacturers, and media.

At the recent Woolworths presentation, chief executive Roger Corbett warned on the sensitivity of household spending to a rise in petrol prices, while Harvey Norman’s Gerry Harvey said fuel prices led to a sharp decline in spending between July and September last year. The oil price is making new highs ahead of the US driving season, refiners’ margins are widening and domestic fuel prices are at $1.40 a litre and heading for $1.50 a litre. I think this time the oil price and domestic petrol prices are going to be higher for longer.

A REGRESSIVE TAX ON GROWTH

It's worth remembering that petrol and energy prices are a regressive tax on growth. They hit low and middle-income earners (global brokers) proportionately harder than high-income earners. We all pay the same price for fuel, and from July to September last year it was low-end and discount retailers who got hit the hardest. Transport stocks also got a solid hit last time we saw fuel prices at these levels, while just about any industrial company that issued a profit warning blamed rising fuel prices.

But it's not only fuel prices that are a regressive tax on growth. I believe we are starting to see some food price inflation break out, particularly in fresh fruit and vegetables. A leading fruit and vegetable retailer has given me the inside scoop on the banana market. Cyclone Larry clearly hit Australia's key banana growing region hard, and it was expected that banana prices would rise sharply in its aftermath. However, for the first few weeks after Larry, the banana price remained about $30 for a 12 kilogram box. The cyclone destroying plantations but it also shook plenty of fruit loose, which farmers collected an sent to market. That game is now up, and supply is tightening. My banana contact paid a record $110 per box for bananas last week, against stiff competition.

I believe there is clear inflationary pressure in the global and domestic economic system, and it only requires any sort of supply interruption in a commodity market to see dramatic price rises. Perhaps the investing world is starting to consider the inflationary implications of the record commodity prices we see today, and I do find it interesting that bond yields are rising globally while equity markets appear to be losing steam. The world is realising these commodity prices come with broader ramifications.

Australian bond yields are trading at the highest level in 12 months '” about 5.67%, up from 5.21% at the start of the year. Ninety-day bank bill futures are yielding about 5.85%. Bonds and bills are reflecting heightened inflationary concerns, and then there is the possibility of an interest rate rise by the Reserve Bank, never good news for industrial equities. In addition, rising bond yields continue to undermine the risk premium for equities, particularly industrials, as rising input prices raise the likelihood of a threat to future margins and earnings.

The warning signs are out for a trading correction in Australian equities. The twin threats of a sharply rising oil price and the rise in bond yields are creating a more challenging environment for the continued outperformance for the industrial side of the equity market. In addition, the sharp rise in base metal prices this year has prompted a capitulation by the "resource bears", and the blow-off in resource equity prices we predicted at the start of the year. Mining stocks are also vulnerable to a trading correction, as are the metals themselves.

I am not a long-term bear on the domestic equity market. I am only predicting a trading correction, which will rouse investors from their complacency. Global growth is strong and the super cycle for commodities remains firmly in place. However, considering the current level of the ASX200, we believe investors have become complacent to the growing short-term risks facing the equity market and the possibility of a trading correction. It is time for some caution, protection is needed.

The biggest mistake investors are making is to buy industrial stocks because the resource sector is doing well. I find it amazing, and dangerous, that investors believe the right course of action is to expand bond-sensitive industrial price/earnings (P/E) multiples during a commodity boom. P/E strength has actually been taken away from the resource sector and added to bond-sensitive industrials. I regard this as a very big mistake.

Don't confuse resource sector share price gains with P/E gains. All we have seen so far is the resource sector move in line with lagging consensus earnings revisions. BHP trades on the same forward P/E as it did three years ago, yet it's fair to say the 2006-07consensus "E" of that equation has never been further from reality. Copper is $3.31 a pound today, and the average broker forecast for 2006-07 is $1.85 a pound. BHP Billiton produces a million tonnes of copper a year.

Investors have been adding to industrials as resources perform, and then switching to industrials on the days resources underperform. That is not the way forward. While Treasurer Peter Costello believes resources are a "fad", Jim Rogers, who co-founded the legendary Quantam hedge fund with George Soros in the 1970s and witnessed the last great bull for commodities and gold, predicted the start of the current commodity super cycle back in 1999. He recently noted that the shortest bull market for commodities lasted 15 years and the longest 23 years. The current cycle is only in its infancy, due to two decades of underinvestment in new capacity and the unprecedented, simultaneous industrialisation of two countries that together account for one-third of the world’s population.

So you can back Jim Rogers, Marc Faber, and myself, or Peter Costello. Either way, it's time to make a choice. You can't sit on the fence any longer. You either need to commit to resources on a medium-term view, or leave the sector entirely. I think you'll get a chance at lower prices through a trading correction, but don't make the mistake that everyone will make of buying more industrial stocks on record P/Es as a “defensive” move. There is nothing defensive about buying an industrial stock trading with no equity risk premium over rising risk-free Government bond yields. There are "defensive" attributes in buying a stock whose earnings are set off forecasts of $1.85 a pound copper, versus a spot price of $3.31. Into the pending trading correction, you will get your last chance to buy resource stocks at silly (low) prices. Don't forget to do it, and don't be fooled into buying expensive industrials.

GO FOR GOLD

I continue to urge you to improve the quality of your portfolio, exit potential "lobster pots", raise some cash, or take out a little index protection. And you should add gold shares, because they will be the only place to hide during the pending correction. Gold shares will prove "defensive", but not a lot else will.

My positive view on gold is widely known and recently I highlighted the powerful long-term underlying forces driving the current secular bull market. Last week, there was further confirmation of the diversification away from the US dollar and the Newmont quarterly report was a reminder of the positive demand/supply fundamentals for gold.

All the fundamentals are in place for the current bull market to exceed the previous peak of $US850 an ounce. We recommend Newcrest Mining, Lihir Gold, Kingsgate Consolidated, Sino Gold, Avoca Resources, Bendigo Mining and St Barbara Limited.

We will get a chance to buy all the high-quality stocks we like for the medium term at lower prices over the next few months, and I again urge you to be positioned for that opportunity.