Seventh inning stretch?

A rookie Federal Reserve Board member set off a huge market rally a few months back by suggesting the Fed's rate rising was in its eight inning. Now I apologise to all the Aussies who know only enough about baseball as I know about cricket in the moniker I've pasted on this post, but there is some notion that generally speaking markets "cycle" up and down and that there are indicia that suggest just where you might be at any particular time in that cycle. It's the kind of stuff you fall back on to rationalise a particularly disingenuous trade or to justify a particular risky one. There is more art than science to the concept, but it does have a great deal of resonance with casual observation.

Alan Kohler puts it in terms of "legs", and he says the market has got a leg up to go (and for some reason I can only imagine a dog against a fire hydrant). He says, "Fear not, even as we enter upon the third leg":

THE traditional sharemarket boom cycle goes like this: in the first stage, interest rates fall and the market wakes up and rises strongly; in the second stage, earnings growth kicks in, companies consistently outperform profit forecasts and the sharemarket rises steadily; third stage is the takeover boom, followed by sharemarket's final spurt, as earnings growth is harder to come by and chief executives need to make acquisitions to keep getting paid in the manner to which they have become accustomed.

We are now entering the third stage: which doesn't mean it ends tomorrow, although there are a few top-of-the-cycle signs around, such as Macquarie Bank's willingness to sell something, and the three-day five-bagger uranium prospector Toro Energy (25c to $1.40 since listing last Friday). But don't be fooled - this is not the final stage of the boom.

Merger mania is upon us because the world is awash with money and because it's an easy way for CEOs to get some growth, or at least to disguise the lack of it. In many cases, for example Tattersall's and UNiTAB, it is just an index play: becoming bigger to climb the index rankings and get a higher rating.

It's not just happening in Australia, far from it. A London fund manager estimates that half of the companies in the FTSE 100 index are now involved in a takeover or are widely expected to be so soon. A European strategist told me he expected an explosion of M&A (mergers and acquisitions) activity in Europe in 2006, as companies look to extract cheaper production costs from an emerging eastern Europe and the big brand owners look to consolidate their market power across Europe.

But the key to the global burst of takeover activity is the cost of capital - corporate debt spreads are as low as they have been for a generation - because risk is being underpriced, on top of historically low bond yields. So while saver/investors are being underpaid for the risk they are taking, the risk-takers are being overcompensated or, rather, they're being given very cheap capital to take risks with.

As a result many takeovers can now be self-funding. Graham Harman at Citigroup estimates that half of the companies in the ASX 200 index could be acquired using 100 per cent debt and still be self-funding because their earnings yield after tax and interest is above the cost of corporate debt. It is enormously appealing for a CEO to make an "earnings accretive" takeover that creates greater scale and improves its position in the index, and the demand for its stock, and therefore his annual bonus. Directors are signalling that they believe their share prices are high, if not overvalued.

So does the apparent maturing of the M&A part of the cycle mean that the sharemarket is about to head south?

No. If anything, the opposite will happen - for a while. In my view global sharemarkets are not near a peak: the US market is about get a new lease on life as the Fed's tightening cycle ends, while Europe and Japan are both at the beginning of powerful bull markets.

In Australia the market has run a long way and small stocks with nothing but hopes - like Toro Energy - are going off like rockets. But the bears have not capitulated yet.

In my view, there will be no "blow-off" in the sharemarket and, therefore, no crash, until there has been a capitulation by the bears - in particular by those investors who refuse to accept that spot commodity prices should be used for their resource company earnings forecasts.

The share prices of BHP Billiton and Rio Tinto have both tripled in three years to $27 and $78 respectively, yet most analysts still use much lower commodity prices than those prevailing now to value them.

Goldman Sachs JBWere this week put out a note hypothetically valuing them using spot prices instead of their own commodity price forecasts: BHP Billiton comes in at $39.99 and Rio Tinto at $101.64 - 50 per cent and 30 per cent higher respectively.

Either commodity prices will collapse soon (very unlikely), or the bears will buckle under the pressure of missing the unstoppable rise of the largest stock in the market and buy in a panic.

That panic, when it comes, might be an opportunity to sell a few to the losers who missed the first 100 per cent of the rise.

Alan Kohler has been around markets longer than Guambat has been tending stew, so it is with more than a little temerity that I get a smight picky on some of his views. My caution stems from the learning process that the markets are going through these days, the "iteration" factor.

I think some of the old processes he describes so well are fast-forwarding. We see that the recovery from external shocks like terrorist bombings has gone from weeks to days to hours. I think there is a set up going on that will actually see the US markets fall on the final rate hike because the traders have already anticipated the notional relief rally. I think the "blow off" will come quicker than we think.

But I do agree with him that we are not there yet. Still, after the huge record-breaking run we've seen in the last short while, which comes on top of a precedentially steep three year run, that there are not enough bears left standing to look for them to capitulate because they failed to use spot prices in their valuation models (an argument always made when commodity cycles are at their top). Indeed, it may well be that the latest run is just the kind of panic buying from endangered bears that he says you've made it to the tender parts of the top of the last leg.

And to add a bit more background anecdotal evidence of the kind that usually shows up near market tops, consider these two articles appearing on the same page as Kohler's komment:

Walker to cash in on the boom and sell up

LANG WALKER, one of the country's more colourful property players, has joined a list of industry tsars and decided to cash out of his multibillion-dollar empire.

Mr Walker, who turns 61 in July, will sell either part or all of his Walker Corp, which has assets worth close to $5 billion and developments in the pipeline worth a similar amount. The property tycoon's wealth was estimated to have risen to $1.16 billion in the 2005 BRW Rich List, up from $759 million the previous year.

Marc Besen, Ralph Sarich and Kevin Seymour are among other property operators who recently revealed they are offloading their shopping centres and office towers at premium prices to take advantage of the strongest commercial market in nearly 20 years.

Reserve warns of market risks

THE Reserve Bank has accused financial markets of "myopia" in their pricing of risk, warning that a significant readjustment may be on its way.

A period of unusually stable global growth and inflation has lulled investors into a false sense of security, the central bank said yesterday, helping to drive global bond yields well below their long-term averages.

"While the current environment of very low volatility may continue, experience suggests that when economic outcomes are consistently favourable over a run of years, investors tend to underestimate, and thus underprice, risk," the central bank warned in its quarterly financial stability review.

However, the Reserve also acknowledged the remarkable resilience of financial markets to potentially destabilising events so far, such as the US Federal Reserve's aggressive campaign of interest rate rises and the downgrading of several high profile corporate bonds. "The global financial system has comfortably ridden-out a number of tests of market sentiment," the central bank said.

And see Risque business and http://guambatstew.blogspot.com/2006/03/bulls-5005-bears-no-where-to-be-seen.html