The Price of Risk in the Stock Market

The disparity between the markets and reality on the ground continues to widen. The November NAB survey showed business confidence plummeted to minus 9 from minus 1 in October.

That takes business confidence to the weakest level since April 2009. In April 2009 the ASX 200 was trading near 3,600 or 22% below the level it’s trading at now.

I’m not saying that we should necessarily be trading at that level with business confidence so low but it’s interesting that we had just experienced a stock market crash back in early 2009. Fast forward to today and our stock market has been rallying for six months and is retesting multi-year highs.

Something doesn’t add up.

Either the stock market is getting ahead of itself or the pessimism in business is misplaced…

NAB said that ‘overall the survey implies a significant slowing in underlying demand and GDP growth in the December quarter, both easing to around 2 ¼ per cent – clearly below trend.’

A closer inspection of the ASX 200 shows that the rally isn’t very broad based. There is a large divergence opening up between different sectors of the economy.

Comparison of Australian Sector Indices

Comparison of Australian Sector Indices
Click here to enlarge

Source: Slipstream Trader

The financials make up a huge part of the ASX 200. The big four banks alone are nearly 25% of the index. So when they rally the index goes up.

Looking at the chart you can see that the financials are rallying strongly at the moment. But the small-cap stocks are not being taken along for the ride. The resources stocks have also underperformed since the start of the year, although they’ve picked up some steam over the last month.

Basically we’re seeing the outcome of the US Federal Reserve’s ZIRP (zero interest rate policy). Yields have been forced so low worldwide that anything with a yield is now being bought with ears pinned back.

Commonwealth Bank [ASX: CBA] is now yielding just under 5.5%. I wonder what yield it needs to get to before the market decides that the risk isn’t worth it? 5%? 4%?

If the market is happy to accept a 5% yield on CBA then the price could rally from its current price of $61.00 to around $67.00 based on the last year’s total dividend of $3.34.

So the rising stock market no longer reflects the prospects of the economy, but instead is a function of low interest rates. This begs the question, ‘Is it worth getting a 5% yield if you lose 50% of your capital?’

CBA fell from $62.00 to under $25.00 from 2007 to early 2009. As we approach that $62.00 level again I don’t think it is an outrageous question to ask.

Australian Interest Rates

Australian Interest Rates
Click here to enlarge

Also, if the Reserve Bank of Australia (RBA) is lowering interest rates due to deterioration in the underlying economy, is that really a signal to buy the stock market? The RBA slashed rates during 2008, and I’m sure you remember what stocks did then.

The level rates are at now is equivalent to where they were after the crash. So either the RBA is panicking or our stock market is oblivious to the risks facing us in the immediate future.

Macroeconomic data continues to deteriorate around the world. China’s trade surplus fell 38% over the last month from $32 billion to $19.6 billion, which is a huge fall. Europe is slowing and going into reverse, Japan is back in yet another recession. America is getting close to stall speed.

But interest rates are lower, so let’s buy the stock market! Yeah, right.

I know I’ve shouted my bearish view from the rooftops, and the fact that we closed yesterday at multi-year highs is making it harder to stick to that view, but it’s only a matter of time until the market tops out and starts heading down again.

The Santa rally appears to be alive and well. We have the FOMC meeting tomorrow night which will probably see the US Fed printing another US$45 billion a month to make up for the loss of Operation Twist.

If there is any good news in relation to the fiscal cliff drama we may indeed see a sharp spike higher in equity markets in the short term.

But unless the RBA plans on dropping rates again in the near term to fire the banks up further, I can’t see the ASX 200 trading that much higher from here.

And I don’t think that RBA governor Glenn Stevens has the stomach to continue dropping rates further in the very near term. A recent article in the Age by Clancy Yeates said that Governor Stevens thinks that, ‘Central banks should be prepared to take the heat out of asset price booms, rather than relying on lower interest rates to “clean up” the mess after bubbles burst.’

If he is prepared to lean on asset bubbles before they become a problem then I don’t think he’ll be that keen to create a bubble by dropping rates too low.

I found another comment by Governor Stevens quite illuminating. He said that:

‘I would have thought that by this point we have to conclude that simply expecting to clean up after the credit boom is not sufficient any more; the mess might be so large that monetary policy ends up not being able to do the job when the time comes.’

I think we all know that that time has already come and gone. ZIRP worldwide and endless money printing is the result.

Murray Dawes
Slipstream Trader

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