Don’t be fooled by the relief rally

Chief Investment Officer and founder of Aitken Investment Management
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There will be good days and bad days for equity investors over the next few months. Clearly, last night was a good day. However, I believe that once again nothing has really changed except for investor sentiment.

The extreme volatility for equity markets continued overnight with the Dow up 2.2% after three consecutive days of losses.

This relief rally appears to have become a regular pattern for the US market over the last few months. However, the main driver is invariably short covering or bargain hunting. Last night it appeared no different, with the financial sector recording the strongest gains led by the investment banks, with Bank of America up 5.9%, while Morgan Stanley rose 5.3% and Citigroup gained 4.2% after some heavy losses.

Markets in the US were also helped along by Chicago Fed governor Charles Evans calling for a commitment to keep interest rates low until unemployment falls below 7.5%. Interestingly, Evans maintained that while this will likely drive inflation outside of the 2% target range, he considered it a lesser evil versus zero jobs growth (our take: BUY GOLD!).

The US Fed also released its Beige Book report on economic activity overnight, which confirmed that the manufacturing decline is accelerating. However, with the market oversold, investors preferred to ignore the bad news and instead focused on Bank of America shuffling its management team. Bank of America shares rallied, despite the fact it continues to suffer major structural issues in a housing market where 20-25% of homeowners have negative equity. Once again, we believe the US market rebound was nothing more than a relief rally.

Similarly, European equity markets rallied between 3-5% led by financial stocks after a few days of double-digit losses. The main driver appeared to be the news that Germany’s top court ruled in favour of the financial bailouts of Greece and other struggling euro members. As a result, it appears nothing has really changed and both Germany and France will continue to bailout the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

The global economy is clearly weak. The prime example is the rumoured US$300bn American jobs package expected to be announced by President Obama tonight, which will have to be accompanied with similar revenue cuts to remain under the newly elevated US national debt ceiling.

We continue to expect US economic growth to remain anaemic at best.

In contrast however, the release of the June quarter national accounts revealed that the Australian economy has rebounded strongly after the devastating Queensland floods. June quarter gross domestic product (GDP) rose by 1.2%, compared with a consensus forecast of 1.1% growth. In addition, the March quarter result was revised upwards to a 0.9% decline instead of the 1.2% drop that was previously reported.

Clearly, the Australian economy, with its leverage to the strong Asian economies, is outperforming its peers. However, the largest contribution to GDP growth in the June quarter was business inventories, which added 0.8 percentage points. It’s worth remembering that rising business inventories are consistent with weaker underlying economic growth.

Therefore, we continue to believe that the earnings visibility in many sectors of the economy remains poor.

In the meantime, we believe nothing has changed and investors should continue to “dance very close to the door” in equities investment. We also recommend a portfolio leveraged to the higher relative growth of the Asian economies, which means the resources and mining investment sectors (note that the race for hard assets continues, with speculation overnight of Anglo or BHP bidding for Walter Energy).

We also expect that in an environment of lower returns, dividend yields will prove to be a differentiating factor in generating investment outperformance.

That’s all for now. Here’s some stock tips for this week:

Intra Energy Corporation Limited (ASX:IEC) – Speculative buy

Intra Energy has completed the acquisition of coal leases in the Songwe-Kiwira Coalfield, north of Lake Nyasa in southwest Tanzania. IEC now holds a 70% interest in the Songwe-Kabulo Mining Licence SML235 and three surrounding Prospecting Licences. Intra’s production strategy in Tanzania has been launched on schedule, with 10kt of thermal coal stockpiled at Mbalawala (Ngaka Coalfield) since mining started in late August. Consequently, IEC’s share price has gained 47% in the past month. We restate our confidence that the ability of Graeme Robertson and his team to develop bulk-commodity and infrastructure projects will help IEC grow into a strong small-cap and even midcap coal producer. Our target share price is $0.55.

Macquarie Group (ASX:MQG) – Hold

We’ve downgraded our share price target for Macquarie group to $28.30 (previously $29.20) after guidance yesterday highlighted the ongoing challenges facing Macquarie Capital, Macquarie Securities and FICC.

Given the headwinds, especially within FICC, we have downgraded the company’s earnings estimates by 3%-4%. The new price target remains below consensus. However, we continue to foresee two value-enhancing alternatives opening up for MQG at the current share price: either being acquired by an offshore bank or private equity interests searching for bolt-on scale in international markets (especially at levels below $23.00); or MQG using its $2.9bn surplus capital to privatise and break itself up to remove its conglomerate discount. While the market believes there is room to cut staff costs, we understand this is not the preference of incumbent management. Based on the massive 23% share price pullback in the past 12 months, there is now sufficient inherent value in MQG to maintain our Hold rating.

CSL Limited (ASX:CSL) – Reduce

Switzerland’s central bank has taken the unusual move of putting a cap on the value of its currency, with the Swiss National Bank to spend whatever it takes to keep the euro from falling below 1.20 francs. This is basically favourable for CSL because it has a large cost exposure to the Swiss franc through its blood fractionation plant. However, we think the current currency situation is already in the share price. We believe the environment is getting progressively tougher, with weakened albumin and clotting factor demand and the re-emergence of Octapharma all likely to be a factors in fiscal 2012. CSL now has an oversupply of albumin and the clotting factors. We think these products will be thorns in CSL’s side, especially with anything above high single digit growth in volumes of the blood product IVIG. Our target price for CSL is $27.00.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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