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The Experts

Michael McCarthy
+ About Michael McCarthy
Michael McCarthy is chief market strategist for CMC Markets in Australia. He has over 30 years of experience in financial markets – specialising in equity trading and trader education.

Is it the season to be jolly?

Thursday, November 08, 2018

Trade wars, US elections, rising interest rates and debt fears. There’s plenty for investors to worry about. Yet many of these market risks are long standing or were well known ahead of time. The market focus on risks may have as much to do with the time of year as the underlying fundamentals.

There are many studies that show there is a seasonality to share market returns. Andrew McCauley at Veritas is one of my favourite quants. His analysis of the Australian share market since 1955 showed the period from May to October underperforms the period from November to April. Interestingly, the same seasonal bias holds for many northern hemisphere market measures, including the US S&P 500 index.

The numbers don’t lie – the bias is real and statistically significant. Explaining why it occurs is a completely different story. Given the effect occurs in both hemispheres, it’s not feasible that it relates to weather patterns or seasons. Tax years also vary from country to country, making it an unlikely cause. And the pattern existed before there was a high degree of international investment, suggesting the activities of one nation or group is not responsible.

Whatever the reason, we are now at the seasonal turning point. A number of factors that are of concern to investors may resolve, or invite a different interpretation. The US midterm elections are a case in point. Investors appear quite comfortable with the change in control of the US House of Representatives, despite the problems that Republicans will now have in prosecuting their stimulus agenda. Instead, the market narrative revolves around the potential for US rates to remain lower for longer. 

This positive interpretation of a lowering of growth prospects could indicate a sentiment shift, and may reflect the move into a more positive period for shares. This has important implications for Australian investors. If US markets resume their upward march, it’s likely local markets will follow. And the Australia 200 index is right in the middle of a decision zone:

If price action is primary evidence, this longer- term chart of the index gives clear guidance on the important levels. For at least three years, the support and resistance levels at 5640 and 6000 have proved important, and with the market sitting about halfway between the two, there is potential for a clear signal of the market direction over the coming days and weeks.

Seasonal effects do not kick in every year, but if sentiment is shifting to positive, we could soon see a test of the 6000 level. A move up through this point would suggest positive momentum into year-end, and a potential test of the post GFC highs around 6375. 

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Stop, Look & Listen

Thursday, October 11, 2018

Many long-term investors are advised to look away from the markets. Market “noise” can be a distraction from enacting a sound investment strategy. Instead, they are advised to check their portfolios on a monthly basis, or even less frequently, remaining focussed on their long-term goals. 

However, there are times when investors should pay attention to what the movement of the market is saying. And with the Australia 200 index at an important inflection point, now is one of those times. The movement of the main index over the coming days and weeks may set the market direction for months to come. 

The chart below gives a longer-term picture of the market performance. Each of the black candles represents a week’s trading. The red line is the 6,000 level. Until late last year this was the post GFC high water mark. The market failed to break through on a number of occasions. This resistance level became a support level once the market broke through. 

The green upward sloping line defines the overall up trend in the market since early 2016. On previous sell downs, the index has bounced off these levels. However, if the index breaks through this trend line (currently around the 5930 mark) it points to the end of an uptrend and potentially a market tumble.

The MACD indicator at the bottom of the chart is adding weight to this possibility. Not only is it nowhere near an oversold position, the increasing red gap between the signal lines is describing increasing downward momentum. 

The good news is that the Australian economic fundamentals underpinning the recent gains remain solid. Whether its trade wars or rising interest rates that acts as a trigger for a sell down, neither is likely to represent a threat of the magnitude of the GFC. This brings us to the yellow line on the chart at 5640. This is an important support level, and largely contained the market downside throughout 2017. In my opinion, this level represents a potential turning point if markets do sell down.

Of course, the support represented by the 6000 level and the uptrend line could hold, and the market may bounce from current levels. If this occurs, investors may consider adding to stock holdings on the view the market will test the 10 year highs around 6380. The next few days should tell.

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Out of Africa

Thursday, September 27, 2018

Australian investors frustrated by state government moratoria on Coal Seam Gas production have alternatives. Unfortunately this means investing outside Australia, and in the case of Tlou Energy (TOU), well outside. Serowe, Botswana to be precise.

In a carbon constrained universe, gas is a viable answer. It is the only existing lower carbon content alternative with sufficient scalability to power homes and industry economically. In Australia, the politics of CSG are toxic. However, in emerging economies, it is not only a compelling option, in many cases it’s the only option. 

TOU is tendering to provide power in Botswana from a methane field. The gas discovery is ready for initial production drilling, expected to commence in October. TOU’s plan is to build a power plant at the site that will start producing 2 megawatts of power, ramping up to 10 megawatts. A 100 km transmission line will be built to link the plan to the national power grid.

Some caveats are required. Clearly, this is a higher risk investment proposition, starting with sovereign, geographical and development risks. The stock is also listed in London. Many large mining companies find UK investor pessimism weighs on the share price. Additionally, the writer holds shares in, and is biased towards this company.

Here’s the chart:

TOU is trading close to support at 10 cents per share, well down on January 2018 levels closer to 30 cents. News flow around a successful tapping of the gas field could act as a catalyst to the share price, and that in itself could attract shorter-term trading participants.

However I’ve added TOU to my portfolio with a longer timeframe in mind. Much of Africa is undergoing significant change, and the continent’s wealth of resources is well established. A company that establishes a reputation for power delivery using local human and physical resources may find long-term demand and opportunity in the more stable societies of Africa. Does any else recall Woodside Petroleum’s humble beginnings on the North West Shelf?

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Not full of ‘crap’

Friday, September 14, 2018

When BHP spun its unwanted operations off in 2015, a number of market wits labelled it “Crapco”. BHP investors, who received South 32 shares for free, bailed out. After an initial six month sell down, South 32’s shares quadrupled from their lows.

South 32 is politely described as a diversified metals and mining company. It produces alumina, aluminium, coal, manganese, nickel, silver, lead and zinc. Apart from coal and aluminium, most of these products are nearer cycle lows. Despite this conservative positioning and a relatively low leverage, South 32 is trading at an unstrained forward Price to Earnings ratio around 10 times.

On August 23, South 32 reported an 8% increase in profit for the full year. Management issued slightly increased guidance costs, as part of an outlook statement some analysts view as cautious. Reactions were mixed, with the stock subject to both upgrades and downgrades. The stock had traded down into the announcement and has bounced since, albeit with higher volatility.

The Materials sector is one of the “cheapest” on the market by traditional measures, such as P/E to Growth, and Enterprise value to Earnings. Surprisingly, it also has one of the higher sectoral expected returns. South 32 is shunned by some because it is expected to see lower earnings from 2021 onwards. However in the short term, it has stonking free cash flows that are likely to find their way into shareholders one way or another.

Further there is evidence this week that the trade dispute is turning in favour of China. Reports that the US is now seeking trade discussions and that China is has battened down the hatches in preparation for a prolonged disagreement may see the performance gap between the S&P500 and the Shanghai composite closing. This potential evidence of a stronger China is supportive of metals and coal prices. The twitter silence on trade from the Oval Office is ominous for the US.

South 32 could be just the ticket as the tide turns, especially for investors who are underweight growth exposure but blanch at the prospect of paying eye-watering multiples for tech darlings.

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Buying falling angels

Friday, August 31, 2018

The investment world is moving towards growth. Reliable income streams and steady earnings profiles will always have appeal, and a place in many portfolios. However the global pressure on bonds and support for industrial commodities speaks to a longer-term trend. The challenge for many investors is that this trend is now well established, and shares that offer higher growth rates are trading at higher valuations.

How can investors buy into growth exposures at a reasonable price? One way is to look for good long-term prospects suffering temporary setbacks. The current company reporting season has produced a number of disappointments. Investors who detect better long-term prospects could view the resulting share price carnage as an opportunity.

Speedcast International (SDA) potentially fits this profile. The company occupies a specialised niche of the telecommunications industry, providing satellite based communication networks and services. Its customers include mining operations, terrestrial telcos that need to reach remote customers, schools, universities and businesses. After its first half earnings report this week, the share price plunged more than 40%.

The tumble came despite the fact revenue grew by 24% and earnings by 14%. The issue is that earnings expectations were significantly higher, and management’s outlook statements can be viewed as cautious. The sellers also appear to place little value on the company’s simultaneous announcement of the acquisition of Globecomm Systems.

In my view, this puts SDA firmly on the radar. While this week’s news creates uncertainty about the future, there is still potential for annual revenue growth over the next three years in the 20% to 30% range. Calculating a Price to Earnings ratio is also somewhat problematic, but I place it somewhere between 10 and 15 times.

The key question for investors is whether or not the disappointment in earnings is temporary or permanent. If the earnings improve from current levels, it’s likely there will be a significant lift in the share price. Buying “fallen angels” is one way investors can add growth exposure to their portfolio without paying an eye-wateringly high price. 

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Two blue chip stocks with higher growth prospects

Thursday, August 16, 2018

The laws of the market are immutable. Risk and reward are directly related. Those seeking higher rewards must seek higher risks, and those seeking less risk must accept lower returns.* Therefore, investors seeking higher growth exposures must look outside the top blue chips. Right? Wrong.

Two top 20 stocks in Australia are offering estimated double digit long term growth. And both reported this week.

Woodside Petroleum (WPL) 

Woodside is the largest Australian-listed energy producer. It was built on the fabulous natural gas resources of the North West Shelf off WA, beginning in 1984. In 2012 it brought the Pluto fields on line, and it’s now well advanced in the planning of the Browse gas facilities. After a period of rationalisation it now has a number of longer term development projects and a cleaner balance sheet.

This week, the company reported a 6% lift in half year profit, and plans to invest $23 billion over the coming year. According to Bloomberg, the average of 16 analysts’ long term growth forecasts was 13.6%. And it will pay dividends of around $1.45 plus franking. Investors who agree that natural gas is the best compromise between the environment and the economy may find these numbers of particular interest.

CSL Limited (CSL)

CSL is a great Australian success story. It’s in the business of saving lives with its blood products. In the last seven years it rose from $26 to levels of over $200. A highly successful research and development culture is complemented by a globally diverse business. Simply put, CSL keeps delivering.

In its full year results this week, CSL not only delivered a 29% lift in net profit, it guided analysts to a 10% - 14% range for profit growth in the coming year. This is well above the profit forecasts for this season, with the top 200 stocks expected to show 5-7% growth. CSL management in the past have “under-promised and over-delivered,” and it’s unlikely many analyst will pull their long term growth forecasts that average 15.6%.

These levels of anticipated growth in blue chip stocks are eye-catching. The challenge for investors is that they can be hard to buy. Pull backs are relatively rare, and generally shallower. Some will baulk at paying $36 for Woodside, or $210 for CSL. Take it from a professional that thought CSL was “too expensive” at $30 and a “sell” at $66, they might be cheap.

*There are many further corollaries. When an investment delivers a much higher than expected return it’s a red flag. In an ideal world investors would revisit the investment to check that the risks were properly understood.  This practice is less popular than it should be.


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Rio returns cash, gets trounced

Thursday, August 02, 2018

Rio Tinto Ltd reported its first half results after the market close on Wednesday Aug 1. Management must be wondering what they need to do. Despite a 12% lift in underlying profit, the highest ever interim dividend and another US $1 billion share buy back the shares were trounced in London trading immediately after the announcement.

One issue is that analysts forecast an even better profit on the back of higher aluminium and copper prices. The US $1.17 dividend reflects a 50% pay-out ratio, so by implication the 15% lift in dividend may also have disappointed. There were minor operational issues that affected some production, and some tricky negotiations with the Mongolian government over a power plant. The CFO also expressed concerns about the impact of a trade war on commodity prices. If these factors drove the market reaction in my view traders are missing the big picture.

Copper production is up 42%. Iron ore production rose 9%. The increased buy back and dividend reflect one of the biggest problems facing management – what to do with all the cash?

If Australian investors take the same approach as their British counterparts it may represent an opportunity. Price to earnings ratios are less commonly used in evaluating resource stocks due to their highly cyclical nature. Investors tend to “look through” the commodity cycle, pumping up the PE at the start of a cycle, and compressing it towards the end. Rio is trading on around 12x times next year’s earnings, and around 10.5x this year’s. At these levels, it suggests the commodity cycle is coming to an end.

However, the fact remains global growth is on an upswing, normally supportive of key industrial metals. Many commodity strategists maintain very conservative estimates of long run prices, in some cases well below current spot prices. These are the reasons any pull back in Rio’s share price could represent good value buying.

The weekly chart shows Rio could pull back to around $76 and remain in an uptrend. If it does, I’ll be waiting.

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Does Rio have further to run?

Thursday, July 19, 2018

In January 2016, Rio Tinto shares (RIO) traded below $40. This month they traded above $80. This doubling in share price by a blue chip stock is a remarkable performance. Naturally shareholders who’ve enjoyed this rise are wondering whether it’s time to take profit. In my view, both the company’s production report and the long-term chart support the idea that RIO has further to run.

This week, RIO told investors it increased iron ore shipments from Australia by 9% in the first half of the year. Bauxite production is up 7%, and mined copper increased by 42%. Its Canadian iron ore operations have returned to normal, and guidance from RIO was pushed to the higher end of previously forecast ranges. On the less positive side aluminium production fell and the company warned of rising costs.

On balance, I read this as highly likely that some analyst will revise their share price targets upwards.

The long term chart is a stark reminder of how far the global mining group could rise in a buoyant environment.

Pre-GFC RIO shares touched $150. The post-GFC high is $89.04. If analysts revise their forecasts and the shares breach this ten-year high, traders could pile in on this share price signal. Note the (green) up trend line. Any positive response to this week’s production report would see it respect the line and continue the trend.

Naturally there are risks. China dominates the seaborn iron ore market. Investors (still) expecting a credit crisis or some other hard landing for the economy in China may have already sold RIO. However given these fears were well expressed when RIO was trading closer to $40 it seems unlikely that those still clinging to this idea don’t own RIO shares.

Another significant risk is that commodity analysts have underestimated iron ore prices. At the peak, iron ore contributed more than 70% of RIO’s revenue. Many estimates for longer run prices are in the $50 to $60 per tonne range. The average over the last year is closer to $70. If commodity prices are revised upward as RIO kicks production, higher the share price action could become explosive.


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Banking on Queensland

Thursday, July 05, 2018

Bank of Queensland is a stock that polarises analysts, according to Bloomberg. Of 16 analysts, 5 say “buy”, 6 say “hold” and 5 rate BOQ a “sell”. The target prices reflect this honest disagreement. The average 12 month target price is $11.08. However the range of target prices is wide, starting at $9.50 and peaking at $13.03. What are investors to do when even the “experts” can’t agree?

One of the drivers of the fall in BOQ’s share price is the earnings downgrades that flowed from the half year results announcement in April. Cash earnings rose 4%, and net profit increased 8%. It’s arguable this was a good result in the current banking environment, but was lower than many forecasts. Commentators honed in on increased funding costs, despite a stable Net Interest Margin.

The effect on the share price was substantial:

This monthly chart of the BOQ share price shows trading this century. The recent, dramatic 30% + fall is at the extreme right of the chart. Perhaps of more importance to investors is the fact that it has now reached an important long-term inflection point at $10.00.

Last month BOQ fell through the level, but then rejected lower levels and bounced back over $10.00. From a technical point of view this is a positive development, and suggests there is a higher probability of further gains.

The rising borrowing costs given as a rationale for the fall are an industry concern, not stock specific. Despite this BOQ shares have dropped more than their peers. Another major challenge for financial institutions is the ongoing Royal Commission into the industry. In my view BOQ’s smaller size and stronger regional focus means it is likely to suffer less from any regulatory fall out.

Good investment choices are a function of investor circumstances as well as the market outlook. If an investor’s portfolio is already 75% banks, buying more bank stock may not add value. However, any investors underweight banks (given 2017/18 performance, well done) or looking to increase portfolio income, could be looking at BOQ right now.

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How gut feel misleads investors

Friday, June 22, 2018

Rising interest rates. Trade wars. Credit bubbles. Housing market fears. Bank misbehaviour. Low wages growth. Low inflation. The list of market worries is extensive. Investors have a lot to fear. Among all this doom and gloom there’s a headline many investors may have missed:

Australian Share Market Hits New Ten Year High

In trading on Wednesday the Australia 200 index broke above the previous, post-GFC high tide mark. In the big picture view of the Australian market, this a highly significant event. The rise came despite weakness in oil and metals prices and a plunging Telstra share price, making it all the more remarkable.

The break to new highs occurred on turnover that was 20% + over average. This is what analysts call “volume confirmation”. From a technical point of view, while the index stays above the break-out point of 6,150, it is now more likely rise than fall. This long term chart shows why this market move is so important.

This is a monthly chart, meaning each of the blue and crimson ‘candles’ represents one month of movement for the index. The mountain on the left of the chart is the great bull run from 2003 to 2007, and the post-GFC fall. The horizontal lines are the previous ten year highs at 6,000, and the recent high at 6,150. The upward sloping line on the right is the up trend that began in early 2016.

The move above 6,150 highlights potential for the market to reach the previous all-time high at 6,852

Very few market watchers had the foresight or the courage to make this call (*ahem* Peter Switzer is one of them). This price action will very likely see many of the more bearish commentators lift their year-end targets for the Australian share market.

Yet for many investors, it doesn’t feel like a bull market. The media focus on negatives for the Australian economy and market could see many investors doubting the strength of the move, despite the unambiguously positive indication from the index.

Ironically this dynamic has potential to sustain the up moves. The emotional phases of a bull market are despair, scepticism, optimism and euphoria. Any scepticism around this market break out fuels later gains if the market rises. The doubters are forced to jump in late if the market continues to gain.

It’s not just investors who doubt the move. CMC markets has two separate platforms – our online Stockbroking pro platform, and the Next Generation trading platform. The trading platform offers a client sentiment indicator that reflects up the minute views of total client position in a market. Here’s the current sentiment for the Australia 200 index:

Two thirds of all traders with a position in the index are short. By value the negative sentiment is even more overwhelming, at 93%. Not only will fear of missing out force investors into the market, gains could be fuelled as traders scramble to buy back their losing short positions.


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