Traps and bubbles

The equity markets globally are navigating a very tricky trading period.

BHP
Source: Bloomberg

The world’s largest economy is on the verge of raising rates for the first time in nine years, and possibly for the third time since 1948, when US GDP was sub-4%. Will it crimp growth and confidence?

The world’s second largest economy China is in the verge of cutting rates for the seventh time in 12 months as it struggles to reach its ‘around-7%’ GDP target. Having seen industrial production fall back to the March low of 5.6% growth year-on-year, which equals the lowest prints of the past 25 years, bets of further cuts are ramping up, and industrial commodities in the interim are taking a further drive.

Europe is on the verge of charging itself more to hold money as its central bank in a further attempt to flush EURs into the economy. While the Bank of England is tiptoeing away from hikes to a neutral, even a slightly dovish basis, suggesting the UK is not a positive as it was.

The macro picture does not make for a conviction ‘buy’ environment nor does it help that the macro picture has created several traps and bubbles as conviction trades become overcrowded or oversold.

The traps:

  • As mentioned at the start of the week, BHP is looking more and more like a trap. The 12-month forward blended price-to-earnings (P/E) ratio is 22 times, which is the highest level in ten years. Iron ore (-36%), oil (-45%) and copper (-26%) over the past year have been decimated and earning expectations for BHP are plummeting by the day. There is a higher chance of BHP being in the teens rather than a high $20 mark in the next few weeks and months.
  • The banks, both macro and micro views are making the banks even more unattractive than they were in August. The housing-led recovery of 2013 is slowing, margins are seeing further signs of compression, meaning the chances of retail rate rises in 2016 will increase and by extension loan growth will slow. Plus, bad and doubtful debts are beginning to show signs of rotating from the bottom of the cycle. And finally the yield aspect of the banks, the ‘progressive’ dividend policy of the past four years is going to have to change – payout ratios will balloon on flat lining cash profits that have to satisfy the progressive yield policy – this is unsustainable.

The bubbles:

  • Powdered milk providers are getting amazing airtime on the ramp up in demand from Chinese consumers. The underlying ‘story’ is compelling however. When Bellamy’s, for example, features on ‘The Project’, you know the good news is in the price. The stock has rallied 496% year-to-date and is trading on a P/E of 100 times – now that’s a static picture. As analysts scramble to keep up with the move, their forward blended 12 month P/E of 36 times still screams overdone. A stock at all-time highs is not something we would suggest going against, but we have seen a pin bar reversal potentially playing out. A close today below yesterday’s opening gap means we could see conditions ripe for a descent move lower as the longer-term capital looks elsewhere.
  • Supplement providers are several weeks ahead of the powdered milk providers. The run up in Blackmores and other such companies saw astronomical P/Es being reached. Blackmores saw a 161% increase in earnings on the China demand story and the 2016 outlook is rosy. But on a 46 times forward P/E with possible supply issues as demand is so extreme it could impact the earnings story. Blackmores and the supplement providers look overdone in the short term.

The trap of going long in the plays of the last four years could be just a trap and the excitement of the new ‘growth’ sectors may need to stabile before entering, as the hot money is primed for a quick exit. There will be a time to enter these play, but with the tricky conditions coupled with the heard trade makes them risky in my view.

Ahead of the Australian Open  

Ahead of the open we are calling the ASX down 18 points to 5105.

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