Why we see another 3-4% upside & where to invest now

James Gerrish

Last week was a fascinating one in equity land with MM again becoming bullish the local ASX200 targeting the 6200-6250 area, now only around 3% higher. It was refreshing to see local stocks, even in the face of the Hayne royal commission, sit in the winners cycle of global indices for the week i.e. ASX200 +1.2%, Canada +2%, UK FTSE +6.3%, German DAX +4%, Japanese Nikkei +4.7% compared to the Dow -0.6%. We maintain our opinion that Australian stocks will outperform their US counterparts in 2018 before taking into account currency gyrations.

  • MM are bullish the ASX200 targeting fresh decade highs around 6250, now only 3.5% higher – interestingly 3 of the major global markets mentioned above rallied more than 4% last week alone.

We saw a very strong broad market over the last 5-days with only some resource stocks plus the banking / financials dragging the chain. However, the banks actually closed the week more or less unchanged in the face of an almost tsunami of negative news flow i.e. their downside feels pretty limited from current levels. Whereas the resources followed our anticipated path in the face of a strengthening $US with Alumina (AWC) -7%, RIO Tinto (RIO) -2.2%, South32 Ltd (S32) -3.9% and Evolution Mining (EVN) -3.9% some of the causalities on the week.

Today we will look into what sectors of the market usually provide the best returns in the final stages of a bull market and subsequently where we want to be invested in the coming weeks / months.

***This is an extract from the Market Matters Weekend Report. For a free 14 day trial of our full service CLICK HERE***

ASX200 Chart

We must remember our bigger picture view for stocks in 2018 /9.

  • MM is still forecasting a major correction of around -20% in the longer-term hence the risk / reward is still dangerous for the bulls even if we are correct with our target of fresh decade highs.

So far in 2018 the MSCI Global World Index has traded in a 10% range between 2009 and 2249, ideally we would love to see one final high to sell aggressively.

The picture unfolding in Europe and to a lesser extent the US / Asia is adding a high degree of confidence to our bullish short-term stance on for stocks.

MSCI Global World Index Chart

The ASX200 is far more correlated to the UK FTSE than say the US S&P500 which makes sense when we consider the respective mining and technology components of both markets. Some standout points catching our eye when we consider the 3 respective indices:

  1. Both the ASX200 and UK FTSE topped out in December 2017 whereas the S&P500 surged +7.4% in January, a move that was largely ignored by many global indices.
  2. The UK FTSE has rallied +9.3% in the last 5 weeks to suddenly be only 3.7% beneath its all-time high, compared to the US S&P500 which is still over 7% below its equivalent milestone.
  3. We are bullish the UK FTSE looking for a further ~6% upside, theoretically good news for the Aussie market.

UK FTSE v US S&P500 Indices Chart

Moving specifically onto the US market the picture is relatively similar with our view moving into Q2 unchanged, we are looking for US stocks to attempt a rally to fresh all-time highs – we are now 65-35 whether they can break above Januarys top, currently 7.6% away.

US reporting season is basically behind us and its undoubtedly been positive, Donald Trump appears to have stopped throwing macro bombs at the market and the US economy is firing nicely thus potentially paving the way for an unusually strong May / June – seasonally the weakest period for stocks BUT we have not rallied into the “sell in May & go away” period as we usually do.

  • Following the recent correction the US markets P/E has fallen to 16.5x from 18.5x, this almost 11% fall creates significantly less valuation risks to the bulls.

Also, with reporting season behind us and the benefits of the US corporate tax cuts about to filter through it feels likely that the “buyback button” which has supported much of this post GFC bull market can again be pressed. A fairly strong rally on short covering would not surprise us.

US NASDAQ Chart

US Russell 3000 Chart

MM is now only holding 17% and 2.5% cash in our Platinum and Income Portfolio’s respectively with a further increase in our Platinum Portfolio last week following the flagged profit taking in our resources holdings - BHP (part profit) and OZ Minerals (OZL) plus small purchase in National Australia Bank (NAB).

MM’s current plan remains to significantly increase our cash levels through 2018, whichever way the market moves.

1 Major stock market tops.

At MM we are looking for a major in the coming months / quarters and interestingly the ASX200 Accumulation Index is now only 1.7% below its all-time high – at MM we believe this is a relevant index for the high yielding Australian market. Our ideal target for this index is around 8% higher before we will baton down the hatches as the risk / reward in our opinion will start to favour a +20% correction.

Numerous articles have been written around how to identify stock market tops, many of them during this very post GFC bull market. As we know this 9-year rally has not been enthusiastically embraced by investors – cab drivers still talk more about Bitcoin than stocks! One of the most frequently asked questions remains “is this the high for the year?” – since the GFC retail investors have generally been looking for reasons to sell stocks as opposed to being scarred of missing out on future potential gains – certainly not a characteristic of a market top.

Fundamentally - What ultimately unhinges stock markets is when investors lose confidence and that is usually triggered by a recession. Well over 70% of bear markets are caused by a recession and this is usually caused by interest rates increasing too fast – maybe on the horizon.

Technically – Only a few stocks drag a market higher (lack of breath), an ever increasing love for “popular stocks” and overall increased bullishness - the second point seems to be unfolding locally.

Hence we continue to quote one of the most famous investors of all-time who was more than happy to miss both market tops and bottoms:

Fortunes are made by buying low and selling too soon. - Nathan Rothschild.

At MM we also believe that market tops in Australia have a Canterbury Bulldogs (Rugby League) catch cry about them – “Who let the dogs out!”. We think this could be about to unfold before our eyes:

Fund Managers find themselves sitting on cash in anticipation of a decent pullback but alas for them the market rallies……..they are not keen to put all their eggs in one basket and continue to chase quality / popular stocks to fresh all-time highs so some of this cash finds itself being pushed into the dogs of the last year i.e. a simple attempt to find some value.

Eight of the ASX200 “dogs” of the last 12-months – ANZ Bank (ANZ) -18.7%, Westpac (WBC) -19.3%, AGL Energy (AGL) -19.8%, QBE Insurance (QBE) -22.3%, BT Investment (BTT) -22.3%, Perpetual (PPT) -24.5%, Telstra (TLS) -24.5% and Domino’s Pizza (DMP) -28.2%.

A pretty poor set of numbers when we consider the ASX200 is up marginally over the same period. Don’t be surprised if we attempt a “cheeky” purchase of 1/2 of this unloved bunch for a short-term play.

ASX200 Accumulation Index Chart

2 Takeover targets

Aside from noticeable bounces in the market underperformers we also expect ongoing takeover activity as companies look to utilise cheap money while enjoying strong balance sheets.

Last week we witnessed private equity pick up its activity in the Australian market with a bid for Healthscope (HSO) including a twist with Australian Super, a major shareholder in Healthscope (HSO), joining the aggressor.

Since 2015 we’ve seen a number of +$1bn takeover bids including Spotless, Toll, Sirtex, Aconex, Duet, Santos, Mantra, Monash IVF Group (MVF), Pacific Brands and now Healthscope. Holding a portfolio with a few potential targets may just get the little extra performance (alpha) we’re all searching for over what’s likely to be a few tricky years.

Large miners like BHP and RIO have been prioritising dividends and other capital return programs to address their over capitalised balance sheets, it’s hard to imagine that both of them are not considering the odd acquisition, here or there.

We will be looking into this subject in greater detail soon in a morning report but some stocks already being discussed in the market over recent months include:

  • Challenger (CGF), Caltex (CTX), Whitehaven Coal (WHC), Ardent Leisure (AAD), Brambles (BXB), Dulux (DLX), Adelaide Brighton (ABC), Nufarm (NUF), Oil Search (OSH), Origin Energy (ORG), Primary Healthcare (PRY), Syrah Resources (SYR), APA Group (APA), Treasury Wines (TWE), Blackmores (BKL) and then of course there’s the old chestnut Myer (MYR).

3 The Resources Sector turns lower on cue

Prior to 2016 MM held almost zero exposure to the resource sector as we saw a painful bear market unfold for most of the sector e.g. BHP fell -69.8% and RIO -58.9% - in fact we put out some very unpopular bearish calls on the likes of BHP. However things have turned nicely following the last few years upturn in commodities which unsurprisingly has coincided with increasing bond yields and rising signs of inflation.

While we remain bullish base metals / resource stocks investors should remember they are volatile beasts which regularly experience significant corrections e.g. Since early 2016 heavyweight BHP has retraced -18.7%, -21.1% plus recently -12.5%. Our plan at MM with resources remains to buy weakness and sell strength – please excuse the cliché.

Over the last 8-days base metals have fallen 6% causing the most damage to some of the ASX’s top performers with corrections for Alumina (AWC) of -13.9% and Western Areas -12% respectively. We believe this pullback is only around half way hence we have no intention of buying resource stocks into any weakness just yet.

Importantly at MM we believe that we are in the later stages of a resources bull market where looking for potential takeover targets may prove the best investment strategy.

  • As mentioned earlier large miners like BHP and RIO have become cash machines but since the GFC and subsequent great downturn in commodities they have been conservative with their CAPEX (capital expenditure).
  • The ideal targets are “bolt on” businesses, perhaps strategically and /or with location synergies plus of course with healthy balance sheets.
  • We will look at this subject soon in a morning report in greater detail.

Bloomberg Base Metals Spot Index Chart

4 MM and the $US

In our 2017/8 Outlook Reports, one of our standout contrarian views was the $US would continue its decline before finding a major low around the 88 level. So far this has unfolded perfectly with the $US declining 15% from its late 2016 high, just when most analysts were bullish due to a strengthening US economy. Now these same analysts have turned on mass bearish the $US, hopefully just in time for our anticipated 8-10% decent bounce.

Contrarian investing can be very profitable when you get it right because the masses are forced to take losses and cover which can lead to dramatic / quick moves but of course the crowd can also be correct, just think of Myer (MYR) – this is one of the reasons at MM that we watch the “Short Reports” closely e.g. recently the short position in our banks has increased steadily.

We often quote that the market likes to move in the path of most pain, the recent USD outperformance has definitely helped that adage ring true – the recent Bank of America Merrill Lynch survey identified the short $US trade as the second most crowded position and the most crowded FX trade.

  • We believe the $US has made a significant low - we are bullish the $US and long via the Beta Shares ETF (USD.AXW).

NB This is what we anticipate will be one of many views that will be “played” via the diverse array of available ETF’s.

$US Index Chart

If this bullish view for the $US proves correct we are likely to see an ongoing correction in base metals / resource stocks which we have been targeting (see Point 3 earlier) - the inverse correlation between the two has been fairly solid over recent years i.e. $US down and resources up.

  • We are initially targeting around a 4% bounce in the $US from Fridays close and a 6% fall in the Bloomberg Base Metals Index.

$US Index v Bloomberg Base Metals Index ETF Chart

5 $US / offshore earners

The $US rallied strongly last week sending some of its key beneficiaries to fresh all-time highs e.g. Macquarie Group (MQG), CSL Ltd (CSL) and Aristocrat Leisure.

We think its too late to unconditionally jump onboard the band wagon but note in point 1 earlier we mentioned a characteristic of major market tops is “an ever Increasing love for Popular Stocks”.

After days like Friday everyone wishes they held more exposure to offshore earning stocks but MM anticipates simply running what we have as opposed to chasing new positions.

Macquarie Group (MQG) Chart

6 When will bond yields have a rest?

Many investors are becoming increasingly concerned as interest rates / bond yields rally above those on offer by stocks, a fairly new phenomenon to many players in today’s market although it’s definitely not yet occurring in Australia. The US S&P500 is yielding around 2% pa whereas US bond yields have now risen clearly above that on offer from stocks i.e. 2-years at 2.48% and 10-years just under 3%.

We actually believe its almost comical that investors thought interest rates / bond yields would remain near recent lows, who could ever understand negative bond yields – economies weren’t that bad people just were scarred and the GFC was fresh in too many minds.

However, rising historically don’t have a negative impact on stock markets, but with yields being so low for so long, we believe it’s very likely this could cause a psychological shift in investor sentiment, especially considering the magnitude of the rally in stocks during this cycle – or at least another painful knee-jerk reaction further down the track.

In the short-term with US 2-year bond yields having accelerated towards 2.5% we actually believe a period of consolidation is not far way before further gains unfold.

We can certainly see interest rates as one potential / logical catalyst for a sizeable share market correction but not just yet.

NB There is now a record position in the US 10-year bonds looking for higher yields which implies to us a rest / pullback is close at hand.

US 2-year Bond Yields Chart

US 10-year Bond Yields Chart

Conclusion

  • We remain net positive equities for the coming weeks / months with a preference for one final high to complete the post GFC bull market advance.
  • We will continue to take profits in our resources positions.
  • We may average our bank positions and / or Telstra.
  • We may look to buy 1-2 takeover targets if they pass our other filters.

We may look to buy / average some of the “dogs” of the last 12-months.

Have a great week

James & the Market Matters Team

***This is an extract from the Market Matters Weekend Report. For a free 14 day trial of our full service CLICK HERE***

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

Disclaimer


James Gerrish

James is a Portfolio Manager within Shaw and Partners heading up a team that manages direct equity and option portfolios. He is also the Primary Contributor to Market Matters, a daily investment report that offers real market insight.

Expertise

ASX:CSL ASX:MQG ASX:TLS ASX:HSO ASX:USD ASX: DMP

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