A correction, not a bear market :: Author: Alan Kohler Date: 01/03/2007 Publication: Eureka Report
PORTFOLIO POINT: Economic fundamentals remain strong, China’s growth is still strong. Markets had been looking for a reason to correct. The important thing to know about the correction that began today is that it kicked off in China after an announcement that a special task force was being set up within the Securities Regulatory Commission to take action against illegal fund flows into the “A” sharemarket in Shanghai.

We’ve been smelling a correction in the air for a for a few weeks, as subscribers know, but of all the possible triggers for it that we might have predicted, a crackdown on securities fraud in China would have been at about the bottom of the list.

It just shows that no matter how long you hang around financial markets, you can always be surprised.

Chinese A shares fell 8.8% after the announcement, which spooked overseas markets and then sent the Dow Jones briefly into free-fall before it closed 3% lower. The local market followed suit today and, as James Frost reports, there was some panic and pandemonium. CommSec’s system crashed at one stage.

The Chinese A sharemarket is to the world sharemarket what the town of Corryong is to the rest of Australia: very small, but with an important weather station.

But the fact that global sharemarkets have gone into a funk because the Chinese authorities want to get rid of the crooks infesting A shares is nothing short of bizarre. You would think this is a good thing.

There is also a lot of talk that high February CPI figure in China will lead to further monetary tightening from the Peoples’ Bank of China, since what they have been doing already clearly is not working.

As Michael Knox of ABN-Amro Morgans told Crikey today: “Before this correction, the Chinese Shanghai Share Indexes had risen by early this week to a level some three times as high as in early 2006. It was clear that they were likely to fall. Now that fall has begun it is likely that we’ll see a technical correction in Chinese stocks of 25–30% over the next six weeks.”

A 30% correction is no laughing matter, of course, but I think two things flow from this peculiar cause of today’s correction:

1. Global markets were looking for a reason, any reason, to correct; and

2. Nothing is really wrong.

This tells me it is likely to be shallower than the 12%, four-month number that interrupted the commodities fun between May and August last year, and that it is yet another buying opportunity.

Yes, I know we keep saying that (it’s certainly what we said last May, although the market took longer than we expected to regain its highs).

But really. profits are rising by 20% or more, unemployment is at 30-year lows, inflation is not a problem, interest rates have stopped rising, business confidence is very strong and, notwithstanding the slump Shanghai stocks, the Chinese economy remains fundamentally strong.

In this situation the only problem for investors is finding stocks that are not overpriced. The companies themselves and the world in which they operate are fine.

If you had been following Charlie Aitken’s advice during February, you would have “de-risked” your portfolio by focusing on quality and building cash. The last thing you should be doing today is selling those good companies and incurring costs; but nor should you be buying more until the dust settles.

Unfounded general panic is the greatest time for a sensible investor, a sentiment backed by a string of market observers I spoke to earlier today.

Craig James,
chief economist,
CommSec

"We’re looking ultimately at a drop of at least 7%."
Stocks mentioned: none.

Alan Kohler: Is this the correction we had to have?

Craig James: I think this is very much the correction we had to have. Sharemarkets around the world have been riding high for a number of months now and without a pause and really this will serve to be the pause that refreshes.

And how deep do you think it will be?

Well I the decline’s in the order of 3% that we’ve seen across the market. Probably have a bit further to do. We may see declines ultimately of 5, 6, 7% before the market starts to settle. The good news is the fundamentals for the economies around the world are in very, very strong shape.

And what’s the best way do you think for an investor to survive such a correction?

Well I think it’s a case of holding your nerve. Looking for buying opportunities in the current environment certainly is probably the best way to approach things and given the fact that the economic fundamentals remain firm there’s no need to panic.

Gerard Minack,
equities strategist,
Morgan Stanley

"It’s just noise but a reasonable-sized correction."
Stocks mentioned: investment banks (negative)

Alan Kohler: Gerard, do you think this is the correction that we had to have?

Gerard Minack: Yes. I mean everybody knew it was a risk and timing these things is always very difficult, but yes I think this is a correction and it is potentially a double-digit decline extending over a month or two.

What’s the best way do you think to survive that sort of correction?

Look, I’d certainly be looking to lighten up on the riskier parts of the market and I think the riskier parts at the moment are your resource companies and more particularly the beneficiaries of the bull market over the last three or four years in financial assets. That’s your financial engineered companies, your investment banks, which I think have all done fantastically well on the way up but I assume will get sold down today quite sharply.

It may be too late to lighten up on things now.

That’s right. Well the only thing I’d say is if it’s going to be a one or two-month affair. Even if you remain bullish over the medium term, I think you can pick these things up even cheaper than you’ll sell them today in a month. Now this is all short-term trading stuff and if you’re a medium-term investor you can probably dismiss this as noise but it could be quite a reasonable-sized correction.

And what’s the significance of the fact that it started in China?

I don’t think it was much significance. I think this is the butterfly that flapped its wings. There had been other potential triggers that seemed to leave markets unfazed. It happened to be China, c’est la vie. It was a bubble. We don’t know where the pricks come from, this time it came from China

Michael Thomas,
futures executive,
IPAC Securities

"Don’t buy anything just yet."
Stocks mentioned: none.

Alan Kohler: Michael, is this the correction we had to have?

Michael Thomas: Look, I think it is a correction that we probably do need along the way on our way up but it’s also part of an ongoing process by the Chinese authorities to try and take the heat out of their economy. They’ve put up interest rates and raised bank reserve requirements in the last couple of months and this is the next step along that path.

And how serious do you think they will be about slowing … taking the heat out of the Chinese economy?

Look, I think they’re very serious. The bottom line is they want a healthy strong growing economy to keep everybody in China happy, but by the same token there’s evidence of bubbles and no more is that more evident than in the Shanghai stockmarket.

So how deep do you think this correction could become?

Well I think we could get a few more days out of it but I don’t have great fears. If you recall back in May last year we had a similar shake out in stockmarkets, emerging markets, commodity markets – in other words, the riskier end of the spectrum – and a month later it was business as usual. I expect a similar thing this time around.

And what do you think is the best way for an investor to survive such an event?

Well, I think the easiest way is to try and sit on the sidelines at the moment and wait for all the smoke to clear. I wouldn’t be advocating jumping in and buying just yet because I think we could have a few more days or weeks of this shakeout but if you’ve got an investment that looks good on the medium term well there’s no reason not to stick to that. I don’t think this is a world changing event.

Shane Oliver,
chief economist,
AMP

"The drop could be 12% but it’s not a bear market; it’s a medium-term opportunity."
Stocks mentioned: none.

Alan Kohler: So is this the correction that you’ve been expecting, Shane?

Shane Oliver: I think it is the correction that I’ve been expecting for some time now. I mean the surprise I’ve had is the way the market’s kept going up and we got to a point where the market had risen, the Australian sharemarket had risen 550 points in about seven weeks or over 10%. We’re certainly due for a correction and that looks like it’s now under way, led by sharp falls in China and the US.

What do you think is the best way to survive this sort of event?

It should be viewed as a correction as opposed to the start of a bear market, so I think it’s really time to look for opportunities, look for buying opportunities. I wouldn’t necessarily be rushing in today even though the market might be off 3–5% or thereabouts, but I would think that over the next few days and weeks there will be opportunities in there to buy because fundamentally I think the market still looks like it’s heading higher. We’ve just gone a bit too far too fast as have many global markets, and now we’re seeing a fall back.

And how deep do you think this correction could be?

Well today the US market’s off about 3.5%. It wouldn’t surprise me if our market fell 5% or thereabouts, and some of the resources stocks might be the hardest hit given concerns in the US related more to global growth outlook and investment demand and also China.

The correction we saw last year, which got under way in May and ended in June, was of the order of about 12% top to bottom, so it wouldn’t surprise me if we see a correction of that order over the next few weeks. So we are looking at something significant here but it’s worth bearing in mind that through the late 1990s every year the Australian sharemarket had a fall of 10–20% yet went on to generate pretty solid gains. So we could see significant further falls but I still don’t see this as the start of a major bear market.

What’s the significance that it started in China?

I wouldn’t necessarily read too much into the fact that it started in China. The Chinese sharemarket rose over 100% last year and was due for a correction. It had a huge, huge run and in fact only the day before yesterday it was at a record level. So the Chinese sharemarket was due for a pull back. I think what’s happened is that the news of a China fall overnight, when the market in China fell almost 9%, has come at a time in the US when there’s a bit of nervousness about the US economy and in particular we saw some weak economic data released overnight in the US. So bad news on China along with weak economic news coming out of the US has made Wall Street traders a lot more nervous than normal and that’s triggered the fall on Wall Street.

More broadly, it highlights the coming of age of China. For a long time it’s been having a major impact on the global economy. Now it’s starting to have a major impact on global financial markets and that’s probably something we’re going to see more of going forward.

Roger Montgomery,
value investor,
Clime Asset Management

"It’s a value investor’s opportunity. Bring it on."
Stocks mentioned: ASX, Blackmore’s, Macquarie Bank, Reece, Reject Shop (positive).

Alan Kohler: Roger what do you think is the best way to survive a correction like we’re now seeing?

Roger Montgomery: Investors now realise that a rising market doesn’t make you a genius and it’s very important to separate good businesses from bad businesses.So if you’ve overpaid for a company and you’ve overpaid for their shares you’ve paid more than what they’re worth, and you’ve just been riding on the coattails of a rising market. If you’ve bought wonderful businesses below their fair value and you know how to identify those wonderful businesses then this is an opportunity to actually buy more.

Often these sorts of events are triggered by something overseas that has no bearing or impact on the operations of the businesses here in Australia, and so what we do is continue to look at how the businesses are performing and how they’re likely to perform and just simply wait to buy more of those company’s shares when they fall below intrinsic value.

How deep do you think this correction is likely to be? Are we likely to have a repeat in your view of what we saw last May?

I have absolutely no idea. And I don’t think anybody does. My hope is that some of the better businesses, some of the businesses that I like – Blackmore’s, Reece, Macquarie Bank, The Reject Shop, the Australian Stock Exchange, those sorts of businesses that have monopoly characteristics and generate very high rates of return on equity – it’s my hope that we’ll be able to buy more shares in those businesses below their intrinsic value. So whatever it takes to do that, bring it on. It would be great.

Tom Murphy,
private client adviser,
Deutsche Bank

"Commodity stocks will offer value opportunities in the next week."
Stocks mentioned: none.

Alan Kohler: Tom, is this the correction we had to have?

Tom Murphy: This is a very healthy move, especially in respect of the Chinese markets. The authorities in Beijing have been telegraphing to markets since January 31 that it is their intention to cool market speculation. They’ve had very little success with this warning and it now appears that what we previously thought would be a couple or rate hikes in the first half of this year may be something quite different.

It may be fiscal action, in other words, on the taxation front coupled with monetary policy action in the next couple of months. The intention is not to kill Chinese growth. Chinese growth has an upward path from now to the Olympics and well beyond, but this is going to reduce speculation in the Chinese sharemarket.

So does it make you more optimistic or more pessimistic?

More optimistic. I think in the United States market we’ve seen volatility levels as low as 10%. The numbers we saw last night, which are in the 15–17% range, are actually much more characteristic of what listed sharemarkets should do. The numbers we’ve been seeing on the volatility front are still low and I’ve been extremely uncomfortable. I do think though that we need to stick with our rate view here, which has been that the US and possibly Australian (interest rates) have peaked, and peaked some time ago. I still continue to believe that before the end of this year both countries will have lower official cash rates, not higher rates.

So how deep do you think this correction could be?

I think it’s going to be relatively short. I think a number of people are talking about a longer correction but I think we will see value present itself in the next week, particularly in the bulk commodity stocks. I am reminding clients that the typical reaction to a sharp, short global sharemarket fall is a second-guessing of global growth prospects.

We think that that second-guessing will cause the cyclicals and particularly the bulk commodity stocks to trade considerably lower in the next week, presenting a buying opportunity. Those stocks are already fairly cheap and they are about the only stocks in the entire market that are cheap. We’ve been at pains to find value anywhere in the sharemarket in the past two months and this will just open up an opportunity.

Justin Bown,
value investor,
Stern Stuart

"It’s time to buy great companies at fair value."
Stocks mentioned: none.

Alan Kohler: So Justin, did you expect to see the correction that we’re now seeing in the markets?

Justin Bown: I’m not a commentator on prices of stocks and so forth but there’s no doubt that the new highs that have been reached sort of suggest that the valuations were probably starting to get stretched to their full amount.

What are the characteristics of great companies that will go well through corrections like this?

All of our analysis shows that what makes for a great company to invest in are those businesses that have got a track record of strong returns on capital. Many, many years of very high returns on capital. That is, they’ve got a proven track record of being able to take investors’ money and invest it at very high rates of return – much higher than what investors could get elsewhere and that’s a pretty rare group of businesses in Australia that have got that.

There’s plenty of companies that have been able to enjoy high rates of return recently, but they don’t have the track record of being able to do that over say, five years or 10 years. They just don’t have the economic model that allows them to do that.

And what does your research show are the kind of top five companies that qualify on both those grounds?

I can give you a list of four or five businesses that have got spectacularly high returns on capital and been able to do that for some time. They include the likes of West Australian Newspapers, the ASX, Woolworths, Macquarie Bank. They’re not necessarily the highest but they’re probably some of the most high-profile and if you think about each of those different businesses, they have built up in one way or another a monopoly-like position that they’re able to exploit for their shareholders’ benefit and it’s those types of businesses that will be able to sustain these sorts of corrections.

Both from the market point of view but also in terms of the broader economy, they’ll be in the best position to be able to sustain those high returns whereas others are more exposed to the rise and fall of the market. They may go well when times are good but when times collapse then their returns collapse. So through the cycle, investors don’t find them investing their money at very good rates.

So your guide for surviving corrections is to buy monopolies?

This is often the time that great businesses return to fair prices. Now I mean we’re saying a correction of maybe 3–4% or so. Some of them are larger than that. That may not be enough to see some of these great businesses return to fair prices because, as you’d well know, we’ve seen some very strong rallies in prices across the board. So it may well be time to look for those opportunities and that’s what investors do in a correction, but look for great companies at fair value rather than look for ordinary companies at fair value. Or ordinary companies at incredible prices.

Gavin Ross,
value investor,
Gavin Ross & Company

"It’s a time to buy big miners, banks and top blue-chips."
Stocks mentioned: BHP Billiton, Rio Tinto, Brambles, Computershare, Leighton and Westfield (positive).

Alan Kohler: Were you thinking this market was good value up until this correction started this morning?

Gavin Ross: Yes I was. We had been finding value in the market – not as much as six months ago or a year, maybe two years ago, but there are value opportunities out there. I see best value in the blue chips and BHP Billiton and Rio Tinto are the stand outs. They are offering earnings yields of 10%. The banks are also looking like reasonable value: they are trading at reasonable discounts. I think a rational investor would see value in the banks.

What's your strategy for dealing with a correction like we are seeing at the moment?

Well, it's not very difficult for value investors; you just keep doing what you've been doing. I am not too disturbed by this at all; I think it will be short term. Basiscally, I see nothing untoward in the global markets. I don't see anything particularly troublesome in the US. As for China, well, I don't have investments in China.

Where do you think the value will be now?

The value picture has not changed to any great degree. BHP Billiton and Rio Tinto remain standouts. Then you have to look at the bigger banks. There are some excellent companies that have just reported strong earnings and they also have a strong outlooks. Personally, I would mention Brambles, Computershare, Leighton and Westfield.

Regina Meani,
chartist

"The upward trend channel is still intact."
Stocks mentioned: none.

Alan Kohler: Regina, did the charts suggest that this correction was coming?

Regina Meani: Possibly not in the steepness of the way that it happened. What we have seen happening on the New York Dow for a while is a divergence in momentum and the index has been wedging up. Normally an upward wedge like that is a sign that there is a correction coming. But I hadn’t had any signal that the breakdown was actually going to occur yesterday, so I’ll be honest about that.

When the All Ordinaries moved through 6000 it actually did a very similar thing to what it did last April/May when it moved through 5000. It actually went through the return line of the trend channel from 2003 and I always call these things a little bit like an out-of-trend experience.

Now we’ve seen the same thing happen with the market moving through 6000. It popped out through the top of that trend channel. It’s only been out there for a couple of weeks. Not quite as long as last year but what we’ve seen now is it coming back into this trend path.

At the moment what has been happening intraday doesn’t actually give me a lot of confidence that the correction is over, but what I would like to see happen today is for the index to get back above 5820, and if it does that it will be a little bit more favourable.

I’ve had a look at a couple of stocks. BHP Billiton and Rio Tinto and they’ve both come back into very significant support areas and they seem to be holding that for the time being. But we may well see this correction extended, and that 5750 would be the trigger point or around that area that it breaks down and suggests that we could see something in the range that we saw in April May and June last year.

So how likely would you say that is?

I think it’s pretty likely that that can happen but what we have to do, of course, is have verification in the break of a trend. At this stage the 2006 upward trend channel is still intact. I would have said that with the weight of this fall that this correction can continue.

What’s the trigger point for the level at which the correction could deepen on the ASX? ..

Well, 5750. I’d allow to 5700 just to make sure that there’s not a false break of that trend. So if we dip below 5700 there’s a likelihood that we could fall into the 5400–5500 range but I wouldn’t expect that to happen in one fell swoop, like in one day. That could be something that could happen over a few months. But at this stage you know, that trend is still intact.

Now this isn’t something that’s overly bearish. It’s not going to end the overall upward swing that we’ve seen in our market. And if you think about it as well, 5000 was all the zeros, 6000 was all the zeros, and that’s a psychological level as well. And also a kind of target area within the trends and popping through the upside of that trend – it all fits together for us having just a breather, a break and a pull back and I don’t believe that it will break any of the major trends in the market. I still think there’s more upside to come.

Two other commentators offer their observations on today’s correction.

John Abernethy, Clime Asset Management

What has happened in the markets is the classic card game played between capitalists and communists or deregulation and regulation. Thus, you have a card game with three capitalists (deregulated markets) and one communist (regulation).

Up to this point in the game the communist has won every hand, but the capitalists have unlimited (maybe) debt finance to play on.

The communist says he wants to take a smoke and go outside for a break. The other capitalist players are left to themselves and realise it is not much of a game if they are playing by themselves with debt.

The problem with the US and European markets is the complete lack of control over credit and cost of money, recently shown by the growth of private equity and substandard residential loan books (securitised) in the US.

Thus, in my view, the problem with world markets is that the capitalist economies are focused on unsustainable growth fuelled by debt-driven consumption. The Chinese economy is be run by bureaucrats trying to direct their economy on a growth path for 50 years. Thus, when serious economic issues become apparent (such as a market bubble) the Chinese will react to ensure the path to growth is sustainable.

Also the Chinese don't need to worry about the next election.

I suspect the US Federal Reserve will intervene in the stockmarkets to stabilise them in the next few days and markets will quieten down. But it is is warning that China will not play the game that the US markets want.

Robert Savage, Goldman Sachs

The end of Goldilocks comes by bears winning back their house. So today brought what was expected by the doomsayers:

1) An unwinding of the Japanese “carry trade” (the exploitation of low Japanese interest rates)

2) Equity correction;

3) Spread widening.

The risk reduction across all markets was notable and it came with real volatility. The trigger for today has been blamed on talk of a Chinese capital gains tax, discussion of by the IMF head economist of carry trade, the continued sabre rattling from the US at Iran and the bleeding of bad news about US sub-prime mortgages. The news of a weaker durable goods from the US sealed the fate of a market ready to switch assets.

US Bonds beat equities. Any port in a storm is the theory, but the practice proves that some places have shallow coves and are still dangerous: witness the drop in gold and the drop in oil. Both viewed as alternative currencies.

The other point about today is that this isn't May 2006 but something entirely different. May 2006 was started by a three-pronged attack on taking away liquidity from the world by the Bank of Japan, the European Central Bank and the US Federal Reserve. While today we have the US market pricing in more rate cuts.

The Bank of Japan has been viewed as 50 basis points and done, and the European Central Bank is similarly expected to hike in March and go away. So its not about liquidity but something else. That something else is the fine balance of growth and inflation: the higher US CPI and the weaker US data is a nasty mix and it’s been reflected in ASX and the like today and for the month, leaving open the worry that we are near the end of Goldilocks. But is she really dead today?

The arguments for keeping optimistic after a day with 98% of the S&P500 down, with US shares off 3-4% and European shares down 5–10% is difficult if not delusional. We will get a lot more data ahead that could whipsaw the negative view of the US in the March quarter and beyond, causing some whipsaw in rate outlooks.

We could also get some real intervention from Asia to support their markets. They have a history of not liking volatile markets, so it seems probable that the pain in Asian shares has some floor … albeit lower than last night.

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