Market rally offers a glimmer of hope

15/04/2009 - 22:00

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POLISHING his crystal ball Briefcase believes that, after such a strong bear market rally on the local and global stock markets, some pullback is likely.

Market rally offers a glimmer of hope

POLISHING his crystal ball Briefcase believes that, after such a strong bear market rally on the local and global stock markets, some pullback is likely. And as commented last week, caution is still required.

This fragile market recovery could still be punctured by any number of exogenous events, such as default on sovereign debt by an eastern European nation or two.

While the market shows resilience in the face of risks, including the possible demise of General Motors, trading profits should be taken and readers need not be moving to be fully invested. Now is a good moment to further reduce debt, restructure holdings and enjoy any brief ray of sun on some stocks.

It is often said that share price movement is determined by earnings expectations, six to 12 months ahead. Ultimately, it is the outlook for corporate earnings per share that drive markets.

Massive falls in the market capitalisation of banks, property developers and trusts, as well as resource companies, reflect not only lower ongoing earnings in the case of resource companies, but also massive asset value write-downs among financial stocks generally.

A strong rally over the past four weeks has taken the market up about 20 per cent, but Briefcase now asks where the risks to earnings lie from here and sees glimmers of hope, although not until later this year.

Even though unemployment continues to rise, there are plenty of good reasons to believe that, after 18 months of global stock market falls, a base may have been formed in March.

It is also important to note that many markets in developing countries have undergone rallies of more than 40 per cent since their recent lows, notable among them China, which will ultimately lead the world out of this recession during the second half of this year.

By most measures, equities look cheap by comparison with other asset classes such as property and fixed interest, but this is only true if we are prepared to believe that the worst is in fact over for corporate profitability.

Also, today's steeply rising yield curve is a sign of a healthy and stimulatory debt market. Recent rallies on equity markets have led to wide participation from large pools of cash that have been accumulating on the sidelines, indicating market participants are now seeing more value in equities.

There are also early signs that economic stimulation packages around the world have begun to take effect. Housing numbers in Australia are showing signs of forming a base, with first homebuyers leading the charge. In the US, which was the epicentre of the sub-prime lending problem, housing inventory overhanging that market has begun to clear.

Lower petrol prices and lower mortgage costs are effectively increasing disposable income, putting more money in the hands of consumers and contributing to an improvement in consumer sentiment, which rose 8.3 per cent in Australia during April, probably assisted by the stock market rally.

Retail sales have also shown signs of bottoming out in the US and the UK. Low prices for goods and services will ultimately begin to entice more buyers, while deferred purchases for replacement of automobiles and other capital items will begin to kick in over coming months.

Meanwhile, corporations are getting their houses in order, which will ultimately be reflected in stable and then rising earnings. Jobs are being cut savagely, leading to rising unemployment, and inventories are being run down, leading to rising productivity. Ultimately, inventories will bottom out and industrial production will recover. We have already seen some anticipation of this, with a stronger oil price and the price of key industrial metal copper, rising from below $US1.40 to more than $US2 per pound, despite industry's denial of any real increase in off-take.

While caution is always called for, Briefcase sees upside to the current market rally, which could take the All Ords Index up a further 430 points to 4,300, with an outside chance of reaching 4,530 points, at which stage the market would have retraced 38 per cent of the past 17 months of pain.

However, in Briefcase's judgement, the global risks are still on the downside for the next few months. Yes, I know that the G20 had a good day two weeks ago, yes I see stimulus packages in many countries and I was impressed by the way the US stock market took an impending Chapter 11 insolvency process by General Motors more or less in its stride, and yes, corporate costs are falling in response to the global financial crisis; but there appears to be lingering risk of further negative exogenous events and more potential for negative earnings surprises than there is potential for further sharp rises beyond my upside targets. The global financial system has taken such a beating that it would not be surprising if it took longer to recover than is presently expected.

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Following on from my work on Queensland's booming coal seam gas (CSG) industry, where high prices are being paid for gas in the ground, last week Mosaic Oil NL agreed to pay 21 cents per gigajoule (Gj) for proven and probable (2P) gas reserves or 10 cents per Gj of 2P plus probable gas at its Churchie project in Queensland. This price reflects the real market for natural gas in Queensland, outside of the red-hot CSG-LNG market, where access to proposed global LNG markets has set a much higher and risky price bar, at prices of around $2/Gj for 2P reserves.

To be fair, the CSG purchases by ConocoPhillips, BG, Shell and others, reflect huge exploration and development upside of the vast, Bowen Basin coal seams, while Mosaic is buying out a project that is unlikely to hold as much exploration potential and its molecules of methane are unlikely to ever find their way into an LNG plant.

The deal to buy Santos out of the Churchie permit, adds 2P reserves of 29 Pj of gas plus 0.57 mmbbls of oil to Mosaic's account from a field which is delivering gas at 2,000 Gj/day plus 25 barrels of oil per day. Mosaic plans to up its activity to take advantage of 100 per cent ownership of the field and its associated processing and transport infrastructure.

Briefcase calculates that Mosaic is extremely cheap with a risked value of 31 cents per share and an enterprise value representing less than $3 per barrel of reserves (or 50 cents per GJ). Briefcase has calculated that the company's exploration interests in PNG have potential to add over 30 cents per share for discovery and development. Ultimately, the company would make an excellent partner for one of the CSG players, providing some conventional gas production, but more importantly, sites to store CSG underground in depleted reservoirs.

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Gold has had a well-earned retreat after a strong run which took it up $A600/oz from $A900 to $A1,500 per ounce and it has bounced from the 50 per cent retracement point at $1,200/oz. A further fall to $1,130/oz is possible, since an International Monetary Fund plan for Central Banks to sell 403 tonnes of gold has spooked the market, but in the past, Central Bank selling of gold has always been a signal to buy.

n Peter Strachan is the author of subscription-based analyst brief StockAnalysis. Further information can be found at Stockanalysis.com.au.

 

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