Rumble: Getting ready for the next market rally

After rallying sharply from the March low, the Australian stock market lost steam in May, down from almost 6,000 to 5,584 points on the S&P / ASX 2000 index.

The retreat came as little surprise: shares had simply rallied too hard since March as investors prematurely became more confident the worst of the US credit crunch was over.

A surging oil price – which hit US$135 a barrel in May – stoked new fears of rising global inflation and higher interest rates.

In Australia, lower earnings guidance, profit taking in resource stocks and the rising local currency weighed on sentiment.

Alpha’s view remains that the March lows were the bottom for 2008 and that the market is basing for a larger rally later this year.

Our year-end target for the S&P / ASX 200 index is 6200 points – about 11% upside from here – confirming our view that now is the best time in several years to gear sensibly into some blue-chip bargains.

Alpha’s strategy is based on five key themes:

A. Fears of rising global inflation will recede towards the end of 2008

The US 10-year bond yield was back above 4% in May for the first time since January, highlighting the market’s concerns about rising inflation.

However, Alpha sees global inflation expectations retreating later this year as slowing global economic growth dampens commodity prices.

Global agricultural prices are down about 20% from their highs and it would not surprise to see oil retreat towards US$100 a barrel later this year as consumers use less fuel and as a rising US dollar takes the edge off oil speculators.

That said, Alpha still believes the long-term trend in oil is up given growth in China, India and other emerging economies.

B. The US will lift interest rates while Australia cuts them later this year

Recent economic data in the United States has surprised on the upside and suggests a downturn in the US economy may be short and shallow.

Increasingly, it is likely the US economy will avoid contraction – though growth in the world’s largest economy will be anaemic this year and next.

The futures market has priced in a US rate hike later this year on the back of an improving economy - which looks about right.

The Australian economy, meanwhile, is still strong, but under more pressure. Interest rates at 12-year highs, the higher oil price and rising food prices are weighing on consumers. Most recently this was seen in retail sales growth being below expectation.

As such, household spending will be weak over the rest of 2008 and the risk is business investment comes off the boil as big companies batten the hatches.

Alpha thinks it unlikely the Reserve Bank will lift rates again this year – even though inflation is still a problem. The slowing global economy will do some of the work for it.

C. But Australian shares will still fall or stay flat for the next three months

Problem one is June end-of-year tax-loss selling. With average share-price losses higher than in previous years, tax-loss selling has been more intense, as seen by the trashed share prices of several underperforming stocks, especially smaller ones.

Problem two is a likely slowdown in resource shares – the big driver of recent market gains – as commodity prices ease in the next few months.

Problem three is the consumer: stocks that rely on discretionary consumer spending will have little joy this year as consumers try to repair their balance sheets.

Problem four is the high Australian dollar: it could still hit parity with the Greenback even though commodity prices will ease. Fears about US inflation will weigh on the Greenback over the next few months before receding later this year.

D. A more sustained, stronger share recovery will emerge around September

May to October is traditionally a weak period for shares and this year will be no different. As highlighted earlier, the next few months could be a rocky time for major economies.

But Alpha believes that by about September, the market will be looking forward to more interest rate cuts in Australia in 2009 – the likely catalyst for a sharp market recovery – and a recovering US economy.

Alpha believes much of the bad news is already priced into the market, especially in financial and industrials.

Earnings forecasts for resource stocks still look high, but it is hard to bet against the sector in the medium-term given the rapid industrialisation of emerging economies.

E. The best way to play the short-term recovery will be in the most beaten-up areas

It is difficult to go past the banks at current prices, especially for long-term investors seeking income, or higher-quality industrial companies that have been heavily oversold.

Alpha’s equity strategy reinforces some important points in this month’s aMail:

• Now is a good time to borrow to buy shares
• Investors should focus on income rather than capital growth
• A volatile market means investors must  hedge portfolios