Market Correction

Market Correction

From Roger Montgomery & Russell Muldoon.

Although we are asked regularly to give our opinion on where we think the stock market is heading, we are loathe to make such predictions because we simply don’t know how to accurately and consistency forecast short term share prices. As you know, we believe that in the short run share prices are moved by unintelligent and emotionally unstable influences and these are unpredictable.

Furthermore, it’s the performance of the businesses that we hold that will determine the return to our investors over the longer run because over longer periods of time, prices follow business performance. The direction of largest two hundred market-weighted stocks that make up the index are not going to help us so predicting the direction of the index is a bit of a waste of time. Usually.

On a few occasions throughout the years, we have sounded a cautionary alarm when the aggregate market price of our portfolio is either at, or has exceed, the valuations of its constituents.

This week, of the 16 completed holdings in The Montgomery [Private] Fund, more than half are now trading at, or in excess of our assessment of fair value. This is the result of strong price appreciation in the past two months.

In the past, this has been a reliable indicator of near term corrections of up to 15% – could one just be around the corner? Of course we don’t know but the ducks appear to be lining up in favour of a set back.

Macro influences are again turning negative. Manufacturing is contracting, the earnings season there has disappointed and many more companies have missed expectations or issued downbeat forecasts than the same time last year. Aggregate debt has moved up despite the country being described as being in a “deleveraging” phase.

Normally, this alone would be enough to worry us and we’d see it as just another part of the business cycle. The issue for Australia however is that conditions in China are also deteriorating. While China reported a sanguine view of the economy:

On the 18th of October The National Bureau of Statistics of China reported: “In the first three quarters of 2012, faced with the complicated and volatile economic environment at home and abroad, the CPC Central Committee and the State Council committed to the general tone of progressing steadily, correctly handled the relationships among steady and comparatively rapid economic development, the adjustment of economic structures and the management of expectation on inflation, paid more attention to maintaining steady growth, carried out the proactive fiscal policy and prudent monetary policy, and made great efforts in policy presetting and fine tuning. As a result, the overall national economy realized steady development with some positive changes: the economic development stabilized; structural adjustment speeded up and people’s livelihood continued to be improved.” You can read the full press release in English here.

The point is all appears to be fine and dandy. And yet, shipments to China from Japan (China’s biggest trading partner) and electricity consumption have both slumped. Electricity, rail haulage and inbound shipments are used by many economists who study CHina to estimate economic conditions because the official numbers have been widely reported by insiders as being rigged.

Previously we noted the deterioration of balance sheets amongst some of China’s biggest steel makers, ship builders and construction machinery manufacturers. In particular we have reported a blow out in both days receivables and total receivables. Its seems the generous credit terms these companies have been offering their clients to front load their sales revenue numbers are now proving to be misguided.

This highlighted to us a collapse in business conditions and we fear that the loans to these businesses will become bad ultimately affecting the banking system there. On top of the on balance sheet risk for banks there is the massive off balance sheet lending and equity investments that have been made through what is referred to as the ‘shadow banking’ system. The shadow banking system is in essence the money invested by mums and dads in wealth management products sold through banks. Many investors believe these are as safe as bank deposits but their funds have been invested in empty buildings, the manufacturing sector, local government financing vehicle, real estate and long term infrastructure that is generating no income. The Bank of China Chairman is reported to have penned an opinion piece for the China Daily in which he said; “…these projects may find it impossible to generate sufficient cash flow to meet payment obligations” and “”moreover, many wealth management products are not even linked to any specific asset, rather just to a pool of assets, whose cash inflows may not often match the timing of scheduled repayments.”

If this sounds to you a lot like the credit boom that went before the subprime reset train wreck of the US in 2008, you might just be right.

And the implications for Australia would be serious.

Next week’s video insight will highlight this issue and we think some caution is warranted.

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.