A few harsh truths about the market

February 25, 2013, 9:47 am David Taylor Yahoo!7

In all my time of watching the market, the downside risks have not been as clear as they are now.

Last weekend in Sydney I was reminded of how powerful nature can be. Strong winds and rain lashed the coastline. I went for a jog first thing in the morning and had to work extra hard as the wind pushed me back. The weather is something that affects us – physically, even.

We can’t always ‘feel’ the economy, but its affects can be just as powerful, especially when you lose your job or see your retirement nest egg halve in value!

Today’s column is a ‘weather warning’ of sorts. It’s for those hard working folks that want to know what’s really going on in the market. I want to set the record straight about recent global developments and explain why the share market had a little tantrum last Thursday.

Let’s first go to Italy. I’ve never been there myself but I hear it’s a nice place to visit. This weekend there’s a general election. Pier Luigi Bersani, Mario Monti and Silvio Berlusconi are all fighting it out to claim victory. Normally an election in Europe might make global headlines for a day or two, but that’d be all. This time around, it’s a little different. See Italy, like many of the euro zone’s periphery countries, is trapped in a recession. The country’s debt level is almost unbearable and the austerity policies being used to tackle all the problems that the debt is creating are equally as painful. So market watchers are getting a little anxious about who the country will decide to elect amid all this mess. In many ways, the last person the market would like to see in charge again is the man who was at the helm during the global financial crisis, Silvio Berlusconi. There are fears he will create even more problems for the debt riddled country.

That said, I spoke with the Co-Dean of Sydney University’s Business School, Tyrone Carlin, late last week and he told me that it didn’t really matter who was elected. He said whoever gets elected will face the same fundamental problem: an economy that's got a chronic debt challenge. So he said unless someone can really tackle the kinds of hurdles that Italy faces in terms of competitiveness, and in terms of getting rid excessive red tape, and the lack of productivity in the country, then it doesn’t matter whether it's Berlusconi or Bersani that wins, we'll just see more of the same problems.

In short, it’s easy to forget that Italy, along with Spain and Greece, has serious challenges ahead of it. And just because Italy hasn’t been getting quite the same level of bad press recently as countries like Spain and Greece, make no mistake, it’s got just as much potential to wreak havoc on financial markets. In fact Tyrone Carlin says he sees many similarities between Italy and Spain. Italy though has one of the deepest bond markets in the world so any serious question marks around Italy’s solvency has the potential to create a financial contagion.

Italy has been hauled back into the spotlight and economists will be watching economic development there very closely in the coming months.

Now to the United States and the market blow-up that occurred after the US Federal Reserve minutes were released.

Last week saw one of those classic market reactions – a reaction that tells you a lot about what’s actually going on in the market. Let me put it to you this way: have you ever driven with someone who’s been in a bad car accident? You’ll find they get more nervous in a close call than someone who’s never had an accident. That’s because they are all too aware of what can happen in the event of a crash... and what it feels like. Investors can behave in a similar fashion. If there’s very little underlying confidence, a relatively small incident can really spook market participants. That’s what happened last Thursday. Reports circulated the globe that some members on the board of the Federal Reserve were growing tired of throwing $85 billion a month of ‘free’ money into the banking system. There were even reports that members were considering slowing down or stopping the quantitative easing program before unemployment falls to that coveted 6.5 per cent level that’s been flagged as the goal to be reached.

The market didn’t like that at all. Traders are all too aware of how much the quantitative easing programs in both the United States and Europe are supporting financial markets. Any suggestion, no matter how small, that it could be coming to an end will rattle the market. If the economic climate wasn’t as electric or as sensitive as it currently is, those reports would not have done as much damage as they did.

In addition to that, rumours were also flying around that a major US hedge fund had run into trouble. Speculation was rife that it had sold out of commodities and resources positions. Mining companies fell sharply on the Australian stock exchange and the Australian dollar fell by a full US cent in the space of 24 hours. In fact the benchmark S&P/ASX200 fell over 2 per cent, and below the so-called ‘psychologically’ significant level of 5,000 index points. I spoke to stock broker Marcus Padley as the drama was unfolding and he said it was typical of a market just following the herd. He said it only takes one big hedge fund to wind out of a position and the rest of the market turns around. Importantly, he added that it was indicative of a nervous and volatile market.

Let’s now come back down to Australia because it’s a good way to tie things off.

The Australian half year reporting season is now two thirds of the way over. So what have we seen? Well the job cuts and restructuring programs that began in earnest last year are helping to refresh corporate Australia. But it’s not enough. Profit margins, in some cases, are growing but it’s more related to cost cutting than bottom line revenue growth. The Fairfax result was a good example of this. The media group turned last year’s billion loss into a profit, but only after sacking 1900 workers and selling of its Trade Me business and some US assets. Media researcher Andrea Carson described it simply as housekeeping and said nothing has really changed, and that Fairfax was still dealing with a weak advertising market.

The share market has been pushing higher and higher over the past few months, but is it all really justified? Given analysts are still concerned about the bottom lines of some of Australia’s major companies, and the CEO’s of Australia’s top two mining companies have now been shown the door, I have to say it doesn’t paint the most robust picture. In addition to that, the market’s shown us it’s not in the mood to handle even the smallest of shock waves. And, as always, the euro zone remains an on-going concern, with even some of Australia’s most senior academics viewing it as a serious threat to the global economy.

By all means enjoy the share market ride to the top, but my view is that this ride is a roller coaster, with plenty of sharp drops, and all sorts of twists and turns. Given how overvalued some of the market’s most ‘defensive’ stocks are (according to one financial planning contact of mine), it seems investors may even be on a ride they’re not all that keen on.

In all my time of watching the market, the downside risks have not been as clear as they are now.

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