Category: Countries & Regions

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ASX 200 lifted by resources

The ASX 200 is advancing towards its medium-term target of 7200 after breaking resistance at 6800. A high trend index trough signals buying pressure.

ASX 200

Primary driver of the advance is Resources. Signing of phase one of the US-China trade deal lifted iron ore, which is  testing resistance at 95. Consolidation at/below 95 is likely, however, given that the mid-2019 peak was caused by supply disruption in Brazil.

Iron Ore

The ASX 300 Metals & Mining index is headed for a test of resistance at 4800.

ASX 300 Metals & Mining

Financials are weak, but the ASX 300 Banks index found support at 7250. Respect of the descending trendline would warn of another decline, with a short-term target of 7000. Penetration of the trendline is less likely but would warn that a bottom is forming.

ASX 300 Banks

The ASX 200 REITs index is testing resistance at 1680, reflecting the investor demand for yield.

ASX 200 REITs

A weakening Australian Dollar may lift exports slightly but reflects concerns over the phase one US-China trade deal and the impact substantive purchase commitments made by China will have on other energy and commodity suppliers. Breach of 68.50 would offer a short-term target of 67 US cents.

AUDUSD

We continue to hold a bearish view on the domestic economy but recognize that the tailwind from resources may partly alleviate this. IT and Healthcare sectors are, in our view, over-priced and we maintain our focus on defensive and contra-cyclical (gold) stocks.

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US Stocks: Bull or Bear?

I have read several commentators proclaiming that the crisis is over and the stock market and US economy are back on track for solid growth. Let’s examine some of the evidence.

The Yield Curve (Bearish)

While the US yield curve has uninverted in the past and yet a recession has still come along, the uninversion seen in recent months coming after such a shallow and short-lived inversion provides confidence that the inversion seen last year gave a false signal…. (Shane Oliver at AMP)

Treasury 10 Year-3 Month Yield Differential

Yield curve inversions seldom last long. For one simple reason: the Fed fires up the printing press to reduce short-term interest rates and boost the economy. The yield curve uninverted before the last three recessions and this time looks no different.

Consumer Confidence (Bullish)

Retail sales kicked up in December, a sign of growing consumer confidence.

Retail excluding Auto

Auto sales are still flat but housing starts have also jumped.

Housing Starts & Permits

Economic Activity (Bearish)

When it comes to economic activity, Cass freight shipments are falling.

Cass Index

Rail freight indicators also point to declining activity levels.

Rail Freight

Employment (Neutral)

Leading employment indicators, such as temporary jobs and job openings, warn that labor market growth is slowing.

Temporary Jobs

Job Openings

But overall payroll growth, albeit subdued is still stable, with the 3-month TMO of non-farm payroll growth respecting the 0.5% amber warning level.

Payroll TMO

Valuations (Bearish)

Last week we compared market cap to profits before tax. This week, we compare to profits after tax. Recent levels above 20 have only previously been exceeded, in the past 60 years, during the Dotcom bubble.

Market Cap/Corporate Profits after Tax

Dallas Fed president Robert Kaplan conceded that expansion of the Fed balance sheet is helping to lift asset prices.

Commenting on the Fed’s massive liquidity response to the repo crisis, Kaplan said that “my own view is it’s having some effect on risk assets……It’s a derivative of QE when we buy bills and we inject more liquidity; it affects all risk assets. This is why I say growth in the balance sheet is not free. There is a cost to it. And we need to be very disciplined about it and sensitive to it.”

This is a clear warning to investors to stay on the defensive. We maintain our view that stocks are over-valued and will remain under-weight equities (over-weight cash) until normal earnings multiples are restored.

Warren Buffett is not infallible but the level of cash on Berkshire’s balance sheet seems to indicate a similar view regarding stock valuations.

Berkshire Hathaway Cash Holdings

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Trump gets his Deal

Donald Trump signed the Phase One US-China trade deal with China’s Vice-Premier Liu He in Washington D.C. on Wednesday.

The deal is important for Trump politically as he needs to disrupt media focus on his impeachment playing out in the Senate.

China attempted to downplay the significance of the deal by sending their Vice-Premier rather than Xi Jinping for the signing ceremony. But the deal is no less important for them in order to halt/slow the relocation of manufacturing jobs by multinationals to avoid US tariffs.

Trivium China sum up the outcome:

  1. We are still in a trade war. Tariffs remain levied on hundreds of billions of USD worth of goods.
  2. A phase two deal looks dead in the water. US President Trump has already said that he might wait until after the November election to negotiate the next phase. More importantly, there is little appetite in China to make concessions on any of the remaining issues.
  3. Third countries are getting screwed. China’s overall import bill is unlikely to jump by USD 200 billion over the next two years, so increased purchases of US goods will come at the expense of producers in other countries.
  4. This deals another blow to the multilateral trading system. The world’s two largest economies just bypassed the multilateral rules-based system to negotiate a deal that undermines the principles of free trade.
  5. China is downplaying the deal. The fact that Liu He – not Xi Jinping – signed the deal sent a strong signal domestically that this is not a big deal. And Chinese officials have said that most of these measures would have happened irrespective of a deal.
  6. Finally, the deal is a positive for stability. This will serve to halt – or at least slow – economic decoupling. That’s a positive for the global economy and security.

Rhodium Group in The Good, The Bad and The Missing focus on what should have been in the deal but isn’t:

  1. Chapter 1 Pledges greater protection for a handful of specific products – pharmaceuticals, medicines and unlicensed software – and generally more enforcement against counterfeit products but the concerns of other industries are not addressed
  2. There are no robust enforcement mechanisms in Chapter 7. It provides a forum for discussion and consultation but not arbitration. If unable to resolve the issue, the aggrieved party can withdraw from the Agreement. This creates little incentive to resolve issues and may result in a logjam.
  3. The managed trade approach does not even start to remedy systemic concerns like the predominance of state enterprises, the prevalence of foreign investment limitations in the vast set of industries that did not get early attention in this deal, the lack of consistency in competition policy treatment and the general asymmetry of information and the playing field for private firms foreign and domestic.
  4. Phase One fails to address growing challenges at the intersection of economics and national security: Huawei and 5G telecommunications, detentions and pressure on expatriates and travelers from the other side, foreign investment screening and export controls, and the threat of financial decoupling.

Rhodium concludes:

The agreement is a limited one, primarily capping the potential for further escalation of protectionism on both sides rather than taking serious steps to address long-standing issues in Chinese trade practices. The managed trade outcomes in which China promises additional US imports are the most significant substantive commitments made, but China’s capacity and willingness to meet these targets remains in question. Significant tariffs remain in place on both sides, uncertainty about the future path of the US-China relationship will persist, and the broader decoupling trends in security-sensitive areas of the bilateral relationship will continue. Progress toward any Phase Two agreement is likely to be minimal in 2020. (The Chinese side immediately said after the January 15 signing that it wanted to go slow before any further talks.)

The deal attempts to head off further escalation but falls well short of addressing long-standing issues with Chinese trade practices. Trade tensions and decoupling are likely to continue.

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ASX Leading Sectors

The ASX 200 broke resistance at 6800, signaling a fresh advance. Expect retracement to test the new support level. Respect would strengthen the bull signal, confirming a fresh advance.

ASX 200 Quarterly

At the same time, fundamentals are distinctly bearish, with falling retail sales and dwindling GDP growth. So, what sectors are driving the index?

A comparison of the ASX 200 sector indices shows that the advance is led by Healthcare and Information Technology sectors, while the laggards are Financials, Utilities and Telecommunications.

ASX Sector Comparison

Top performers in Healthcare (with forward price-earnings ratio where available) are:

  • Polynovo (PNV) – negative eps
  • Clinuvel (CUV) – 79
  • Pro Medicus (PME) – 137
  • Nanosonics (NAN) – 158
  • Resmed (RMD) – 55
  • CSL (CSL) – 49
  • Fisher & Paykel Health (FPH) – 55

ASX 200 Healthcare Top Performers

In Information Technology, top performers are:

  • Afterpay (APT) – negative eps (forward pe 476)
  • Nearmap (NEA) – negative eps
  • Bravura (BVS) – 37
  • Appen (APX) – 58
  • Xero (XRO) – 5998 (forward pe 270)
  • Altium (ALU) – 63

ASX 200 Information Technology Top Performers

The graph below compares PE Ratios on the y-axis to required Annual Growth in earnings on the x-axis. The curve plots the compound annual growth (CAGR) required for a 20-year income stream to deliver a 12.5% return on investment.

PE Ratio compared to Expected Growth

What this illustrates is that PE Ratios above 50 should be treated with caution as they assume the ability to maintain high CAGR in earnings (e.g. above 20%) for long periods. Even when growing off a low base that can be difficult to achieve.

Bottom line: many stocks in these sectors (Healthcare and IT) are highly-priced and vulnerable to strong draw-downs.

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Playing the long game

Chart for the Week

GDP growth is slowing, while US corporate profits (before tax) are also declining as a percentage of GDP.

Corporate profits Before Tax/GDP

Yet the S&P 500 and other major indices are rising, lifted by Fed liquidity injections in the repo market. The red line shows total assets on the Fed’s balance sheet.

S&P 500 and Fed Assets

The Long Game

We play the long game — reducing exposure to equities when market risks are high and staying on the defensive until normality is restored — even if this means sitting on cash while equities rise. The only alternative, unless you trust your ability to accurately identify exact market tops and bottoms, is to hang on to your positions no matter what happens. But there are few individuals who can withstand the stress and make rational decisions during a major market draw-down.

Updates for Market Analysis Subscribers

Best wishes for the New Year. It promises to be an eventful one.

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S&P 500: Stocks lift but jobs and profits a red flag

The S&P 500 has advanced steadily since breaking resistance at 3000.

S&P 500

Lifted by Fed liquidity injections in the repo market.

S&P 500 and Fed Assets

Optimism over improved global trade has spread, with the DJ Euro Stoxx 600 breaking resistance at 400.

DJ Euro Stoxx 600

South Korea’s KOSPI completed a double-bottom reversal to signal an up-trend.

KOSPI

And India’s Nifty Index broke resistance at 12,000.

Nifty

Commodity prices remain low but rising Trend Index troughs on the DJ-UBS Commodity Index suggest that a bottom is forming.

DJ-UBS Commodity Index

Crude spiked up with rising US-Iran tensions but is expected to re-test support at 50 as supply threats fade.

Nymex Light Crude

Fedex recovered above primary support at 150, but the outlook for economic activity remains bearish.

Fedex

Falling US wages growth warns of slowing job creation.

Average Hourly Wages

Declining employment growth highlights similar weakness.

Employment Growth

Initial jobless claims, while not alarming, are now starting to rise.

Initial Claims

Growth in weekly hours worked has slowed, with real GDP expected to follow.

Real GDP and Weekly Hours Worked

While GDP growth is slowing, corporate profits (before tax) are also declining as a percentage of GDP.

Corporate profits Before Tax/GDP

Market Capitalization of equities has spiked to a ratio of 20 times Corporate Profits (before tax), an extreme only previously seen in the Dotcom bubble.

Market Cap/Corporate Profits before Tax

The market can remain irrational for longer than you or I can stay solvent, but this is a clear warning to investors to stay on the defensive.

We maintain our view that stocks are over-valued and will remain under-weight equities (over-weight cash) until normal earnings multiples are restored.

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Australia: Bearish apart from mining

Household disposable income lifted in response to the recent tax cuts but households remain risk-averse, with consumption still falling and extra income going straight to debt repayment — reflected by a jump in the Saving ratio below.
Australia Household Saving

Housing prices are recovering despite high levels of mortgage stress in the outer suburbs but building approvals for new housing continue to fall. Construction expenditure is likely to follow.

Australia Building Approvals

GDP growth is falling, while corporate profits (% of GDP) remain in the doldrums apart from the mining sector.

Australia Corporate Profits

Low household disposable income and corporate profit growth in turn lead to low business investment (% of GDP).

Australia Business Investment

Low investment leads to low job creation. Job vacancies and job ads both warn of declining employment growth.

Australia Job Ads

Cyclical employment growth is expected to slow in line with the fall in the Leading Indicator over the past year.

Australia Leading Employment Indicator

We maintain a bearish outlook for the Australian economy, though Mining continues to surprise to the upside.

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ASX 200 breakout

The ASX 200 broke resistance at 6800, signaling a fresh advance. Expect retracement to test the new support level; respect would strengthen the bull signal.

ASX 200

Primary driver of the advance is resources. Talk of an imminent phase 1 US-China trade deal lifted iron ore, which is now testing resistance at 95. Expect retracement to test primary support at 80 but respect would confirm that a base has formed.

Iron Ore

The ASX 300 Metals & Mining index is advancing in step with iron ore prices, with a short-term target of 4800.

ASX 300 Metals & Mining

Financials remain weak, with the ASX 300 Banks index ranging in a bearish narrow band between 7200 and 7500. Respect of the descending trendline would warn of another decline, with a short-term target of 7000.

ASX 300 Banks

The ASX 200 REITs index recovered after a false break below 1580, with a short-term target of 1680.

ASX 200 REITs

We maintain a focus on defensive and contra-cyclical (gold) sectors because of our bearish outlook for the Australian and global economy.

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ASX 200 hesitant because of banks

Financials are still weak. The ASX 300 Banks rally appears short-lived, posting a red candle for the week. Expect another test of support at 7200; breach would test primary support at 6750.

ASX 300 Banks

The ASX 200 REITs index recovered above support at 1600. False breaks on both the bull and bear side indicate hesitancy but declining peaks on the Trend Index warn of long-term selling pressure.

ASX 200 REITs

The ASX 300 Metals & Mining index is more bullish, having broken resistance at 4450. Expect retracement to test the new support level; respect would confirm the target of 4800.

ASX 300 Metals & Mining

Talk of an imminent trade deal lifted iron ore above previous support at 90. Expect another test of primary support at 80, but respect would confirm that a base is forming above 80.

Iron Ore

A bearish financial sector is holding the ASX 200 back. Follow-through above recent weekly highs would signal another advance, while reversal below 6600 would test primary support at 6400. Further consolidation between 6400 and 6800 is just as likely given the gradual decline on the Trend Index.

ASX 200

We are avoiding highly-priced growth stocks and focusing on defensive and contra-cyclical sectors because of our bearish outlook for the Australian and global economies.

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What is causing the current S&P 500 rise and how is it likely to end?

In November 2007, six months after the inverted yield curve (3M-10Y) recovered to a positive slope, bellwether transport stock Fedex broke primary support at 100 to warn of an economic slow-down.

Today, two months after rate cuts restored an inverted yield curve to positive, Fedex again broke primary support, this time at 150. Their CEO observed that the stock market might be booming but the “industrial economy does not reflect any growth at all.”

Fedex

Real GDP growth is slowing, with our latest estimate, based on weekly hours worked, projecting GDP growth of 1.5% for the calendar year.

Real GDP and Weekly Hours Worked

While real corporate profits are declining.

Corporate Profits Before Tax adjusted for Inflation

What is keeping stocks afloat?

First, a flood of new money from the Fed. They expanded their balance sheet by $375 billion since September 2019 and are expected to double that to $750 billion — bringing total Fed holdings to $4.5 trillion by mid-January — to head off an expected liquidity crisis in repo and FX swap markets. The red line below shows expansion of the Fed’s balance sheet, the blue is the S&P 500 index.

S&P 500 and Fed Assets

Second, ultra-low bond yields have starved investment markets of yield, boosting earnings multiples. P/E of historic earnings rose to 22.01 at the end of the September quarter and is projected to reach 22.82 in the December quarter (based on current S&P earnings estimates).

S&P 500 P/E (maximum of previous earnings)

That is significantly higher than the peak earnings multiples achieved before previous crashes — 18.86 of October 1929 and 18.69 in October 1987 — and is only surpassed by the massive spike of the Dotcom bubble.

How could this end?

First, if the Fed withdraws (or makes any move to withdraw) the $750 billion temporary liquidity injection, intended to tide financial markets over the calendar year-end, I expect that the market would crash within minutes. They are unlikely to be that stupid but we should recognize that the funding is permanent, not temporary.

Second, if bond yields rise, P/E multiples are likely to fall. 10-Year breakout above 2.0% would signal an extended rise in yields.

10-Year Treasury Yields

China has slowed its accumulation of US Dollar reserves, allowing the Yuan to strengthen against the Dollar (or at least weaken at a slower rate). Reduced Treasury purchases are causing yields to rise. The chart below shows in recent months how Treasury yields have tracked the Yuan/US Dollar (CNYUSD) exchange rate.

CNYUSD

Accumulation of USD foreign exchange reserves (by China) is likely to be a central tenet of US trade deal negotiations — as they were with Japan in the 1985 Plaza Accord. Expect upward pressure on Treasury yields as growth in Chinese holdings slows and possibly even declines.

Third, and most importantly, are actual earnings. With 98.6% of S&P 500 companies having reported, earnings for the September quarter are 6.5% below the same quarter last year. Poor Fedex results and low economic growth warn of further poor earnings ahead.

We maintain our view that stocks are over-priced and that investors need to exercise caution. We are over-weight cash and under-weight equities and will hold this position until normal P/E multiples are restored.

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