ASX: Dead cat bounce

The ASX 200 found support at 6450/6500 followed by a hesitant rally: a candle with a long tail followed by a short-bodied evening star. This resembles a typical dead cat bounce. Breach of 6450 is likely and would warn of a decline to test support at 6000.

ASX 200

Gerard Minack in a recent report suggested that Australia is likely to go into recession if the saving ratio increases. For the past few years, consumption has been growing at a faster rate than disposable income as households dig into savings to maintain their lifestyle.

Australia: Consumption, Disposable Income & Saving

Households may continue this behavior because of the wealth-effect (they feel asset-rich but cash-poor) but are likely to reverse sharply if housing and equity prices fall. Which is what we are witnessing at present.

Australia: Housing Prices

In our view, the housing decline is likely to continue despite the RBA cutting rates. While rates may be attractive, job prospects are looking shaky. Loan approvals are falling.

Australia: Housing Loans

Business investment is falling.

Australia: Business Investment

Job ads are about to go over a cliff. Trade tensions with China will add to our woes.

Australia: Job Ads

Public funded infrastructure construction is slumping.

Australia: Public Construction

Credit and broad money supply growth are approaching 2009 GFC lows.

Australia: Credit & Broad Money

And our iron ore tailwind is dying fast. Iron ore spot prices have fallen off a cliff. Breach of support at 95 is likely and would warn of another decline to test support at 80.

Iron Ore

I plan to further increase the level of cash in our Australian Growth portfolio.

S&P 500: Treasuries reflect flight to safety

10-Year Treasury yields plunged below 2.0% on Donald Trump’s announcement of further tariffs (10% on $300bn) on China. The fall reflects rising demand for Treasuries as a safe haven in these turbulent times.

10-Year Treasury Yield

The spread between 10-Year and 3-Month Treasuries recovered above zero. This is a bearish sign: recession normally follows the recovery and not the initial inversion.

10-Year 3-Month Treasury Spread

The S&P 500 retreated below 3000 on Trump’s announcement, strengthening the bearish divergence signal on Twiggs Money Flow which warns of a correction. A test of support at 2750 is likely.

S&P 500

The Russell 2000 ETF (IWM) is expected to test primary support at 145. Small cap stocks have lagged the S&P 500 this year, highlighting risk aversion.

Russell 2000 Small Caps Index

Dow Jones Euro Stoxx 600, reflecting large cap stocks in the European Union, is similarly headed for a test of primary support at 365. Strong bearish divergence on the Trend Index warns of a reversal.

DJ Euro Stoxx 600

Falling commodity prices reflect market concerns for the global economy. A Nymex Light Crude breach of $51/barrel would signal a primary down-trend. Declining peaks on the Trend Index warn of selling pressure.

Nymex Light Crude

The DJ-UBS Commodity Index is similarly headed for a test of support at 75. Breach would signal a primary down-trend. A peak near zero on the Trend Index warns of strong selling pressure.

DJ-UBS Commodity Index

Dr Copper, often used as a barometer of the global economy, has breached primary support at 5800, signaling a decline. Again, a Trend Index peak below zero warns of strong selling pressure.

Copper

Employment stats for July have improved slightly, with Average Hourly Wages growth easing to 3.3% (Total Private).

Average Hourly Wage

And annual payroll growth ticked up to 1.5%

Employment Growth & FFR

But weekly hours worked are declining, warning that real GDP will decline further, after printing 2.3% for the second quarter.

Real GDP & Weekly Hours Worked

I have warned my clients to cut exposure to the market. It’s a good time to be cautious.

“Price is what you pay; value is what you get.”

~ Benjamin Graham

Gold rallies as the Dollar retreats

A tall shadow on the Dollar Index warns of selling pressure. Breach of the new support level at 98 would indicate a test of the rising trendline at 96. A Trend Index peak below zero warns of selling pressure. A weakening Dollar will increase demand for Gold.

Dollar Index

Spot Gold is testing resistance at $1440/1450 after consolidating above short-term support at $1400. A Trend Index trough above zero indicates buying pressure. Breakout above $1450 is likely and would offer a short-term target of $1500/ounce.

Spot Gold in USD

ASX: Iron ore plunges

Iron ore spot prices plunged from $120 to $106.50/tonne in two days. Penetration of the rising trendline is highly likely and would warn of a strong correction. A spike up is often followed by a spike down.

Iron Ore

The ASX 200 retreated from its 2007 high at 6830. Penetration of the rising trendline is now likely and would warn of a correction. The first line of support is 6350, with stronger support at 6000.

ASX 200

We have increased the level of cash in our Australian Growth portfolio.

Apple Inc. (AAPL) – window dressing with buybacks

Apple (AAPL) is a notable omission in my international model portfolio. Here is one of the reasons.

Michael Santoli at CNBC reports that Apple’s sales and earnings over the past 4 years are essentially flat. The only metric that has improved is earnings per share (EPS) because of stock buybacks. Shares in issue have shrunk by 20.7%, from 5.8 to 4.6 billion.

Apple (AAPL) Metrics

Let’s break this down.

Earnings per share grew by an average 5.7% over the past 4 years, of which 0.2% was from actual growth and 5.5% from buybacks. Apple spent $170 billion on stock buybacks in the 4 years to September 2018 at an average of $150.85 per share.

Apple Stock Buybacks

In FY18 buybacks totaled $72.7 billion, or 7.5% of current market cap ($965.4 bn), well above its earnings of $59.5 bn. Apple is distributing capital to stockholders by way of buybacks.

FY19 estimated earnings yield is 5.4% and dividend yield is 1.4%, leaving retained earnings are 4.0%. Far less than the buyback yield. The company has heaps of cash and can basically keep doing this for a long, long time. But it erodes shareholder value.

Total return investors can expect, if they buy at the current price of $213.04,  is 5.6% (5.4% earnings yield and 0.2% actual growth). That is all that Apple will earn on the money invested into buybacks. An admission that the company is standing still, powerless to inject new growth.

A PE ratio of 17.9 appears modest but it isn’t if you only have 0.2% growth. That amounts to a PEG ratio of a staggering 90 times growth!

Bottom Line

Apple is no longer a growth company. Earnings are shrinking in real terms and the only way the company can maintain the illusion of growth is by buying back stock at exorbitant prices.

Australian banks: Still overpriced

Summary

We have just completed a review of Australia’s four major banks — Commonwealth, Westpac, ANZ and NAB — and conclude that they are collectively overpriced by 23.5 percent. Our review is based on APRA’s quarterly reports, where the four banks can be viewed as a collective unit.

The ASX 300 Banks Index ($XBAK) is in a primary down-trend and we expect it to re-test support at 7000.

We estimate forward PE at 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we calculate a combined fair value of $310.7 billion, compared to current market cap of $406.1 bn, based on a 13-year payback period.

Our conclusion is to wait for $XBAK to re-test support at 7000.

Future Growth

Total assets are the base which generates most bank revenue. Heady growth of the last two decades is unlikely to continue. Growth in total assets has lagged GDP since 2015. Private credit growth for Australia slowed to 4.4% in FY18 and 3.3% in FY19.

Majors: Total Assets to Nominal GDP

Private borrowers are near saturation point, with household debt at an eye-watering 190% of disposable income.

Australia: Household Debt to Disposable Income

David Ellis at Morningstar writes:

Many investors are concerned about a potential sharp downturn or crash in the Australian housing market. While Australian housing is expensive and debt/household income ratios are high, we remain comfortable for several reasons despite recent weakness in house prices. Tight underwriting standards, lender’s mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, a high proportion of variable rate home loans, and the scope for interest-rate cuts by the Reserve Bank of Australia, or RBA, combine to mitigate potential losses from mortgage lending. Average house prices in Australia are falling, with the national average declining 5% during the 12 months to end December 2018 based on CoreLogic data. But investors who readily compare the Australian residential real estate market to that of the U.S. and other markets are ignoring fundamental differences.

The counter-argument is that loose lending policies exposed by the Royal Commission, vulnerable mortgage insurers with concentrated exposure in a single sector and low bank capital ratios have created a banking sector “more likely to act as an accelerant in a down-turn rather than a shock absorber” in the words of FSI Chair David Murray.

Nominal GDP is growing at an annual rate of 5.0% (March 2019) and we expect this to act as a constraint on book growth. We project long-term book growth of 4.0%.

Margins

Net interest margins declined to 1.73% for Q1 2019 and we expect a long-term average of 1.70%.

Majors: Income & Expenses

Expenses declined to 1.10% of average total assets but non-interest income has fallen a lot faster, to 0.60%. The decline in non-interest income is expected to continue and we project a long-term average of 0.50%.

Fees & Commissions

Fees and commissions — the major component of non-interest income — have suffered the largest falls, with transaction-based fees the worst performer. Lending-based fees are likely to be impacted by declining credit growth.

Majors: Fees & Commissions

Expenses

Operating expenses have also fallen but sticky personnel costs are declining at a slower rate.

Majors: Expenses

Non-Performing Assets

Charges for bad and doubtful debts remain low but we expect an up-tick in the next few years and project a long-term average of 0.20%.

Majors: Provisions for Bad & Doubtful Debts

Capital

Common equity Tier 1 capital (CET1) remains low, with a CET1 capital ratio of 10.7% in March 2019, based on risk-weighted assets. If we calculate CET1 as a percentage of total assets, the ratio falls to 4.9%. Leverage ratios, which calculate CET1 against total credit exposure, are even lower because of off-balance sheet exposure.

The Reserve Bank of New Zealand has asked the big four Australian banks for “more skin in the game” and to increase their capital holdings in New Zealand subsidiaries by $12 billion:

The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”.

The move by RBNZ has exposed ineffectual supervision of major banks in Australia. A new chairman at APRA could see increased pressure on Australian banks to improve their capital ratios.

Management & Culture

Australian regulator APRA is suffering from regulatory capture. There have been calls in Parliament and the media for APRA chairman, Wayne Byers, to resign after the Royal Commission revealed numerous shortcomings in bank culture and supervision.

A 146-page capability review, stemming from David Murray’s Financial System Inquiry found APRA “slow, opaque, inefficient, and in urgent need of a culture and leadership overhaul.”

Clancy Yeates at SMH weighs in:

A rare public intervention from banking royal commissioner Kenneth Hayne could be aimed at ensuring his recommendations are not watered down by financial sector lobbying, former watchdog Allan Fels says….

“It’s very unusual for a royal commissioner, especially a former High Court judge, to speak after a report, but probably he is concerned about weak implementation of his report due to enormous pressure from the financial institutions, an enormously powerful lobby.”

There have been several recent changes at major banks whose poor conduct was exposed by the Royal Commission. NAB CEO Andrew Thorburn and Chair Ken Henry resigned in the wake of the findings. Earlier, in 2018 Ian Narev resigned as CEO of Commonwealth after an APRA investigation into money-laundering found there was “a complacent culture, dismissive of regulators, [and] an ineffective board that lacked zeal and failed to provide oversight.”

A change at the head of APRA could have even more long-lasting consequences for the banks.

Valuation

We project:

  • long-term asset growth at 4.0% p.a.;
  • net interest margins at 1.7% of average total assets;
  • non-interest operating income of 0.5%;
  • operating expenses at 1.1%;
  • provisions for bad/doubtful debts averaging 0.2%; and
  • a 30% tax rate.

That delivers a forward PE of 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we arrive at a combined fair value of $310.7 billion (current market cap is $406.1 bn) based on a 13-year payback period.

Technical Analysis

The ASX 300 Banks index, dominated by the big four, reflects a primary down-trend. The recent rally is currently testing resistance at the descending trendline. Reversal below 7000 would warn of another decline. The previous false break below 7000 suggests strong support.

ASX 300 Banks Index

Conclusion

Expect another test of support at 7000. Respect of support would provide an entry point at close to fair value.

Valuations are sensitive to assumptions: LT book growth of 5% and a 0.1% increase in net profit (% of average total assets) would increase intrinsic value to $387.4 bn (4.6% below current prices). At present we favor a conservative fair value of $310.7 billion, 23.5% below current market capitalization.

We currently have no exposure to the four major banks in our Australian Growth portfolio.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above companies.

Be wary of investing in a rigged market

The S&P 500 recovered above 3000, suggesting another advance, but bearish divergence on Twiggs Money Flow warns of (secondary) selling pressure.  Further tests of new support at 2950 are likely.

S&P 500

Falling commodity prices warn of declining global demand.

DJ-UBS Commodity Index

Declining crude prices reinforce the warning.

Nymex Light Crude

While in the US, the Cass Freight Index formed a lower peak. Follow-through below the previous trough would warn of a down-trend and declining activity.

Cass Freight Index

Capital goods orders, adjusted for inflation, continue to decline.

Capital Goods Orders

Housing starts are steady but declining building permits warn of a slow-down ahead.

Housing Starts and Building Permits

Craig Johnson of Piper Jaffray says odds of a recession are growing:

“The bond market has already priced in two rate cuts at this point in time, and potentially part of a third,” Johnson said. “History has always said that bonds lead equities and we need to listen to that message. I think that’s what the smart money is doing…I guess we can’t seem to quite get off of the monetary train that we’ve gotten ourselves onto, and I don’t think it’s quite so simple.”

S&P 500 PEmax

Trailing price-earnings (PEmax) are above 20, historically a warning that the market is over-heated. The biggest buyers of stocks are the companies themselves, through buybacks. The Fed is expected to cut rates while employment growth is still strong. Price signals are being distorted.

Be wary of investing in a rigged market. It’s a good time to be cautious.

“It is optimism that is the enemy of the rational buyer.”

~ Warren Buffett

Iron ore tailwinds lift the ASX

Further increases in iron ore prices are predicted. Enrico de la Cruz at Mining.com reports:

Singapore-based steel and iron ore data analytics firm Tivlon Technologies is keeping its price forecast of $150 a tonne by October.

“We expect the launch of infrastructure projects in China to peak in the third quarter and further uplift demand for steel,” it said in a note.

Narrow consolidation is a bullish sign, suggesting another advance.

Iron Ore

The Materials index continues its up-trend. A Trend Index above zero would signal increased buying pressure.

ASX 200 Materials

Financials continue to test resistance at 6450 but face headwinds from the housing market and construction.

ASX 200 Financials

The ASX 200 is testing its 2007 high at 6800. A rising Trend index indicates buying pressure. Penetration of the rising trendline on the index chart is unlikely but would warn of a correction.

ASX 200

We maintain a high level of cash in our Australian Growth portfolio because of expected headwinds from housing and construction.

Gold: The rally continues

The Dollar Index is testing resistance at 98; breakout would offer a target of 100. The stronger Dollar has softened demand for Gold.

Dollar Index

Silver is retracing to test its new support level after breakout above $16. Respect of support at $16 would signal an advance to $17.50. Gold and silver tend to move in unison.

Spot Silver in USD

The Gold Bugs Index, representing un-hedged gold stocks, is retracing after a strong rally. A correction of short duration would be a bullish sign, suggesting another advance.

Gold Bugs Index

Spot Gold continues to consolidate above short-term support at $1400, indicating buying pressure. Upward breakout is likely and would offer a medium-term target of $1500/ounce.

Spot Gold in USD

S&P 500 selling pressure

The S&P 500 is retracing to test its new support level at 2950. Bearish divergence on Twiggs Money Flow warns of (secondary) selling pressure. Breach of support would warn of a correction to test primary support at 2750.

S&P 500

Sector indexes are approaching a watershed moment, with Autos rallying to test their descending trendline.

S&P 500 Automobiles

Retail is also headed for a test of its rising trendline after making a new high.

S&P 500 Retail

Even Semiconductors have recovered to test their 2018 high at 1450.

S&P 500 Semiconductors

I still believe it’s a good time to be cautious.

“Be fearful when others are greedy and greedy only when others are fearful.”

~ Warren Buffett