Vivid Financial Commentary

Jon Reilly - Vivid Financial

Vivid Financial Monthly Commentary October 2008

The month of October has traditionally been a volatile one. The 2008 version was particularly so… consider the following statistics for equities and commodities:

Equities
• October was the worst month for the companies in the S&P500 in 21 years, since the 1987 stock market crash.
• Global equities in October shed $9.5 trillion.
• October was the most volatile in the 80 year history of the S&P500.
• America had the most down days in a single month since August 1973.
• During an eight-day streak at the start of the month, the Dow lost 2,396 points.

Considering days with 4% moves up or down: there were none from 2003 through 2007; only three throughout the 1950s and two in the 1960s. As for October 2008, there were nine days with moves of more than plus or minus four percent, which edges out September 1932’s record of eight.

Commodities
• Copper and Crude Oil had their worst one-month losses ever.
• Crude Oil futures lost one third of their value, this was their biggest monthly percentage drop since trading began in 1983.
• Gold lost 18% for the month, representing its worst monthly drop since 1980.

As noted in our blog entry on the web site from October 31, several of the indicators that track various measures of volatility and credit markets have started to show signs of improvement. We again see many commentators asking just how much more bad news can there be that is not already priced in at current levels.

Self confessed market bull Charlie Aitken at Southern Cross Equities believes that the worst case scenario has already been accepted and discounted by current share prices.

Using BHP as an example, he estimates that the company is trading on about 5.5 times earnings for 2008/09, down significantly from both the recent highs of 11.5 times and the long term average for the resources sector of 14 times.

The fall from just the recent high implies that BHP’s earnings will decline by about 52% during the current financial year. Aitken makes the exceedingly valid point that this is nigh on impossible given that about half of BHP’s earnings are contracted and locked in until March of next year.

In the meantime, BHP’s share price has fallen 50% from the recent high of $50. He suggests that a worst case scenario is already being discounted into the share price after the recent correction.

In the listed property trust sector we are now at multi decade lows. The S&P/ASX200 property index got to a level of 900 on October 30, the last time it was there was briefly in January 1991, and prior to that November 1987.

We have commented in the past that the prognosis for the Australian economy appears relatively robust. Applying even the most pessimistic outlook one can imagine still would not seem to warrant the absolute capitulation we have seen in this sector.

The view of our Reserve Bank outlined below suggests that when fear does eventually subside and buyers return to the market that there will be a strong rally in this sector.

RBA Commentary
Our Reserve Bank Deputy Governor gave a speech at the end of October that contained some interesting observations. We have heard much about the fact that our economy is in better shape than many others, so it is good to see someone put some flesh on the bones of this argument.

A selection of comments from Ric Battelino’s speech follows:

On Chinese demand for our resources:
It would be naïve to assume that China will not experience an economic cycle, so we should expect its demand for our resources to fluctuate. However, China’s strong long term growth potential must be a source of optimism about our own long term prosperity, given our role as one of its most important suppliers of raw materials.

On potential returns from share markets:
The one-year forward earnings yield on Australian shares has risen to 11 per cent, well above the long run average. This is a very attractive yield. When the yield has risen to these levels in the past, the return on shares over the subsequent 10 years has almost always been well above average.

On the Australian housing market compared with the US:
US house prices stopped rising essentially because the supply of houses overtook demand… The overhang of unsold houses in the US has created downward pressure on house prices as builders and developers have been forced to sell. This is absent in Australia.

Battelino goes on to note that another key difference is that the borrowers targeted by Australian lenders had much better ability to repay loans than did the Americans who took on obligations they could not manage. He points out that the home ownership rate in Australia was no different at the start of our boom than it was at the end. As a result, the arrears rate in Australia is also no higher than it was at the start of the boom, and is low by international standards.

In Conclusion:
The next couple of years will be noticeably more subdued than the past five. We should not be surprised by this as the income and wealth generated over the past five years were simply extraordinary.

By definition, the economy must grow at a below average pace for some of the time. These periods provide the economy with the breathing space to sustain the expansion. There is no reason to assume that the next year or two will not do the same.

US Presidential Election
By the time you read this the Presidential election will have at least been contested, whether we have a result or not will perhaps depend on the lawyers. Although many polls are forecasting that Senator Obama and the Democrats will have a sufficient margin to ensure that this time the election will not be decided in the courts.

Historically, there is little to suggest that either party has had a significantly better track record at managing the economy. What has been more often sited in the past is the importance of the actual presidential cycle, not which party is occupying the Oval Office.

Historical trends suggest that the year of an election has generally been a good one for the markets, and that the first year of a new presidential term has been not so good. The veracity of the trend is questionable at best, as the last three Presidents have all seen good share market performance in their first years in office.

Similarly, the last year of a presidency is supposed to the best of the four year cycle, which clearly has not been the case during 2008. What should be more important, assuming the predictions are correct, is the genuine opportunity for the Democrats to undertake significant structural reform, or the New Deal II as it has become known in the media. This may just provide the catalyst that the American economy needs to begin its long path back.

The economic landscape for the new President will not be a pretty one. The American economy is very much a consumer driven one, and that same consumer has for many years lived beyond their means, using home equity withdrawals to keep buying the production of other countries, mainly China.

Commentator John Mauldin reports that over 2% and sometimes over 3% of GDP growth in 2002-2006 was the result of rising housing prices, allowing consumers to borrow against their homes and spend on mainly discretionary items.

He has also produced the following chart and makes the point that without this additional spending that George W Bush would have presided over a two year recession in 2001 and 2002, and would likely have only been a one term president.

Interest Rates
Finally a quick comment on interest rates, in the context of the Reserve Bank cutting by 75 basis points in their November meeting. The markets were expecting a 50bps reduction, so the move to cut by 75bps marks the second month in a row where the RBA has surprised the markets.

We are fortunate to have the capacity to do so, and it is worth noting that the 5% rate is generally a considered a neutral policy stance. So in fact, the significant moves which have shaved 2% off rates in the last two months has only brought about a removal of the restrictive stance that had previously been in place.

By comparison to the United States and Europe and especially Japan, our central bank still has significant scope to stimulate our economy.

DISCLAIMER: The information contained in this document is for general information purposes only. It is provided in good faith and is not intended as advice. It does not take into account any individual circumstances, objectives or particular needs. We strongly recommend that you seek professional advice from one of our advisers before making any decisions on your tax or financial planning. Vivid Financial Pty Ltd is a Corporate Authorised Representative No. 317 682 of Australian Financial Services Limited (AFSL 297239 ABN 50 116 900 362).