egolinews.com

It may not always be readily apparent in daily life, but in financial markets too much of a good thing definitely turns into a negative.

A few weeks ago I predicted the share market would likely reach for new highs and as I write this story on Wednesday afternoon, both major indices in Australia have been trading firmly above their January highs, but they once again seem unable to hold on to those levels.

If anything, given the strength of economic data and indicators that have been released across the globe this past week, one would have assumed an even stronger advance would have occurred by now.

The problem is, however, one of share market valuations. Sure, we're all aware that equities are trading on lofty multiples if we look at FY10 profit predictions alone, but even on FY11 forecasts the share market is now reaching out for a pretty full-looking valuation.

On my previous calculation, which remarkably has not changed to date, the Australian share market would be fully valued on FY11 profit estimates if and when the ASX200 index would reach close to 5200. With the index edging ever closer to 5000, this level is now almost within 200 points.

That calculation is based on 14.5x times consensus FY11 EPS forecasts for the main ASX-listed companies. If we apply a more cautious multiple of 14, then this market has about 40 or so points left.

Note: this is on consensus forecasts for FY11. We will only receive detailed insights into FY10 results in August, at the earliest.

None of the above is on its own sufficient to trigger a correction, but it will keep the less trigger happy investors at bay.

Here's another observation I have made this week (and the previous one): stockbrokers and other advisors have started to switch preferences and exposures. Changes made vary from going Underweight base metals (in plain English: reducing exposure) to going Overweight Healthcare stocks (increasing exposure).

With regards to the first group, there is now a widely carried view that investor sentiment, or call it market momentum, has taken the lead in most commodity markets, and not demand-supply dynamics.

As I have pointed out repeatedly in the past, this in itself does not mean current momentum cannot carry these markets any higher. In fact, there's probably a reasonable chance we might yet see higher prices for copper and oil and the likes because technical analysis points towards higher targets. (When investor sentiment rules, technical trading rules threefold).

It does indicate that when market momentum reverses, any losses will quickly develop into a much larger correction than seems justified on the basis of what happens in the real world. We've already seen one such example this year. We might yet see another one.

As far as Healthcare stocks in Australia are concerned, I think every investor should be aware of two very important observations:

1.) many healthcare stocks look fully valued at present share prices
2.) many healthcare stocks are beneficiaries of a stronger US dollar

As such, I wouldn't be surprised if healthcare stocks turn out the outperformers if and when risk assets make a turn for the worse, but it won't be because of intrinsic valuations. It will be because of their direct link to a strengthening US dollar.

(All this, of course, on the general assumption that the greenback will stick to its safe-haven status in times of diminishing risk appetite).

Against this background I have found it very curious that a growing number of market experts is turning positive about gold again. Last week (on April 1 I kid you not) the team of highly regarded chartists at Citi warned their clientele the next upturn for gold was now "imminent". Their target? US$1300/oz.

For those who are not avid followers of gold priced in USD: the current price is around US$1134/oz and gold has remained in a tight trading range since correcting from its mini-bubble in December last year.

This week US based market trader Dennis Gartman joined the Citi team by turning more positive on gold's outlook, observing the recent price chart pattern seems to point into the direction of an imminent break out, possibly to levels last seen in December (that's above US$1200/oz).

Yesterday, Craig Ferguson, market strategist at Australian hedge fund Antipodean Capital, reported to his clientele he had now turned "Super Bullish" on gold. Even if the US dollar were to strengthen over the weeks ahead, Ferguson still maintains gold will perform well.

He predicts gold will soon rally to prices "well above" US$1230/oz (December reference target).

Previously, Antipodean Capital had positioned itself short crude oil on the same basis as many other experts did: market fundamentals are still a bit weak for these high prices and technicals initially seemed to start breaking down as well.

But things have changed rapidly in the light of ongoing better-than-expected economic data releases. Market momentum is now pointing to higher prices for copper, for crude oil, and for various other commodities, suggests Ferguson – better to listen to what the market is telling us.

At least for now.

Beyond the immediate horizon Ferguson believes the US dollar remains poised to stage a significant come-back on the back of strongly rising US bond yields. That'll be the trigger to push risk assets, such as equities, into a serious correction.

Economic developments since the start of the year have forced him to push out this moment of reckoning. At this point in time, he believes it won't occur much later than half-way this calendar year.

While I do not necessarily agree with Ferguson's view of a significant market correction ahead (I'd rather let economic data and corporate profits do the talking), I do agree with the view that market momentum has improved considerably over the past weeks. To the point that any correction in the short term is likely to remain limited in size (maybe similar to what happened between mid-January and mid-February?).

I do agree with Ferguson's view that economic momentum seems poised to take a few steps back from the third quarter onwards and it remains yet an open question how financial markets will respond to this.

I guess it'll all depend on how big the loss in economic momentum will turn out to be. Economists at IHS Global and at the Economic Cycle Research Institute (ECRI) -two leading indices I have been following closely since the beginning of the year- are both sticking to their forecasts the US economy will slow down from around mid-year onwards, but neither of them foresee any real disasters.

I suspect that by then Chinese attempts to slow down economic activity will have started to gain more traction as well. In Australia, a higher proportion of too optimistic home owners will be in more pain by then as well.

All in all, not much has changed since I wrote my story titled "Short Term Momentum, Longer Term Worries" (March 22, 2010), but there are a few changes since then that deserve every investor's attention.

1.) The distance between various equity indices and their 50 day moving average has again ballooned to levels that in the past more often than not preceded a pull-back. If you want to see this for yourself, simply go to Yahoo! Finance and look up the All Ordinaries in combination with the 50 day moving average on a twelve month price chart

2.) The TechWizard reports there is now clear divergence between price action for the Dow Jones Industrial Average and the MACD indicator – history shows this is often a leading indicator for a pending retreat

3.) I am a close follower of global investor risk appetite as measured by economists at UBS and according to their latest update (this week) risk appetite is once again stretching out into extremely bullish levels. While historically this index has seen higher levels, these all-time peak levels were not much higher than this week's reading. This would suggest we are close to a peak and thus steering towards a general retreat in risk appetite once again.

Anecdotal evidence suggests there are quite a few investors who have been taking some equity exposure off the table as the end of March approached. This includes professional advisors and their clients.

At first consideration, this seems to make a lot of sense. Ever since the global share market rally got on solid footing from June-August last year the usual pattern implies that strength will be replaced by weakness every time we move into a new calendar month. And then, as we move into the second and the third week of the month, strength returns and pushes the share market to a higher level.

This time around there is widespread speculation that portfolio adjustments by large institutional investors have been responsible for most of the direction of equities, currencies, bonds and commodities during the final days of March.

This period also happens to coincide with the closing of the first quarter and thus everything simply had to move into the "right" direction, or so the rumour mill goes, to allow the big players in the industry to advertise with another stellar performance for their funds under management.

If we assume this is correct, then some of the movements we have witnessed during the final days of March should reverse soon as we progress through April. The most obvious one would be a reversal in the EUR/USD trend, which should translate into weakness for commodities and for equities.

This will be even more so the case if yields on US Treasuries start rising again (bonds selling off).

Of course, if we assume that April will simply continue the pattern as described above, then those advisors and their clientele I was referring to in my opening paragraph will be rewarded for their strategy. Supporting their confidence will be the fact that history shows April is usually one of the better months for equities and commodities in the year.

Offsetting this, however, is the fact that March is usually not that good, albeit still positive. March 2010 has been exceptionally good by everyone's standards. This poses the obvious dilemma for investors: has March pulled forward some of April's upside?

So far, nothing of the story behind equities' rise in February and March has changed. One of the emails that is currently going around inboxes at various stockbrokerages throughout Australia contains a chart compiled by someone at Bell Potter, illustrating that economic data releases throughout Q1 this year have mostly surprised to the upside.

This chart is simply another way of showing what I have been highlighting over the past weeks: both corporate results and macro-economic releases have forced economists and analysts to upgrade their expectations. This automatically provided a valuation boost to equities because of the simple fact that higher earnings expectations make stocks cheaper, and thus more attractive.

This process is still ongoing. On Wednesday, just before the start of the second quarter, both Deutsche Bank and BA-Merrill Lynch issued big upgrades to commodities prices and thus for earnings, valuations and targets for related companies.

Add an unexpected take-over offer for Macarthur Coal ((MCC)) on the same day and it is clear overall dynamics for equities, materials stocks in particular, remain positive.

However, that is only one side of the story. Another rather popular email that is currently doing the rounds is one that reflects back on the last time producers of iron ore and coal (bulk commodities) enjoyed such large price rises as this year.

That was back in 2008, and similar to what has been happening this year share prices had been in strong demand prior to the outcomes of the annual negotiations. But it went all downhill afterwards.

To refresh everyone's memory: in anticipation of what was at that time a record jump in annual prices BHP Billiton ((BHP)) shares touched $50, then retreated to rise again to $46 on the official confirmation of a negotiated 80% price rise for iron ore. Six weeks later the shares were at $36.

I am sure nobody needs me to come up with some key differences between now and then -global expectations are on the rise this time, to name but one- but there is a key message behind this email which should not be ignored: offshore investors are questioning whether BHP and the likes are once again at risk of being valued at peak cycle earnings.

To feed their suspicion further, price targets in the market are again trending towards $50, which is the highest level BHP shares have traded at over the past three years (they did so on two occasions). So unless we are about to see further material upgrades to economic growth projections and demand forecasts for base materials and energy, I don't think we will see BHP shares close the gap with these $50 targets anytime soon.

These problems will be solved, of course, if and when we do see some price weakness first.

At first thought, this would only temporarily solve the problem, but, and as pointed out by Deutsche Bank analysts in their sector update, historical trends suggest prices for commodities are more likely to take a step back in quarters two and three.

Such scenario is backed up by analysis of BHP's annual share price patterns throughout the present decade. Investors who don't feel like repeating the data analysis themselves: the best times to buy BHP shares tend to be in Q3 and the best times to sell tend to be towards the end of Q1 as BHP shares traditionally book their biggest gains each year between October and March.

I think the odds are in favour this will once again prove to be the case this time around. The facts speak for themselves. In early October last year BHP shares traded at $36. They closed today at $43.59 (but have traded higher this month). The difference is 21%. Even if BHP shares would manage to fill the gap with the $50 targets between now and late September, this would still only represent further upside of less than 15%.

But let's, for now, concentrate on April. Because apparent share price valuations remain largely dependent on what will happen between now and next year, in other words: it's not so much FY10 that matters (as that has been priced in many times over), but FY11.

To illustrate this with a BHP example: no matter what happens to this year's earnings forecasts, the shares remain expensively priced. But they look very good value on FY11 estimates.

What goes for BHP, goes for the majority of the share market, including the banks.

Under such circumstances share markets take the character of a glass filled to the max with liquid. Everyone carrying it through the room has to walk very carefully to avoid any spillage. And of course, as per usual, there are plenty of dangers around that can cause spillage.

On April 15, the US Treasury Department is scheduled to release its findings into whether China should be branded a currency manipulator, or not.

Last week, former Fed Governor Alan Greenspan branded rising yields on US Treasuries "the canary in the coalmine". His timing was near perfect as yields have been rising, and they have attracted the interest of worried investors the world around.

Both events took place against a background of disappointing bond issues, both in the US and elsewhere. To make matters worse, history is usually not kind for US Treasuries in April. 10-year yields have risen in each of the past four April months, and in six out of the past seven.

This year, investors in equities will have to bank on a below average increase as the average rise over these past April months has been 25 basis points. On top of recent yield rises, a repeat of the historical average could well spook investors worldwide.

There is also the expected come-back of the US dollar. Much of the rallies in the final week of March have been fuelled by a sudden come-back for the euro. What if US dollar strength reasserts itself? (Investors better not lose out of sight that Greece has to roll over some EUR15bn in government bonds through to the end of May).

The most important danger for the outlook of risk assets, however, stems from disappointing economic data. The leg up since mid-February has received firm support from positively surprising data. How long will this last? And if it does, how long before this starts impacting on interest rate expectations?

If we take a positive approach though, it might just be that April simply brings investors more of the same ingredients that have accompanied the global rally since March last year: a wall of worry, with too many unbelievers on the sidelines, and few daredevils that continue pushing share indices to higher levels.

At least history also shows equities tend to perform best between November and May, so it may well be that all of the worries above are a bit too early on investors' minds.

To paraphrase US author Hall Borland: Will April turn out the promise, that May is bound to keep? Or is April finally ready to live up to T.S. Elliot's description this year: the cruelest month, breeding lilacs out of the dead land, mixing memory and desire, stirring dull roots with spring rain?

It is quite extra-ordinary what has been happening over the past few weeks, and I am not referring to the fact that equity markets (outside the US) and commodity prices are approaching new highs for the past twelve or eighteen months.

Risk appetite is back in global financial markets, there can be no doubt about it.

Is it justified? Well, that is what I was referring to in my opening sentence. As more and more economists are updating their projections on the basis of recent insights and indicators, growth projections for 2010 continue moving higher. For the US, for China, for Australia.

The only region that seems to be missing out on this global phenomenon is Europe where austerity measures by the Greek and Spanish governments are just one reason for reduced growth expectations this year.

This flood of constant upgrades is pushing up expectations for corporate profits and this, as I explained in the past, is providing global equity markets with a free bonus on the valuation side.

In other words (and this might seem strange at first sight), share markets have become relatively cheaper (thus more attractive) over the past month, even though they have risen quite strongly since the last bottom in mid-February.

Probably the best way to illustrate this is by making a straight comparison with mid-January when major Australian equity indices were at (more or less) similar levels as they are this week.

In my first editorial of the year on January 18 (still called Rudi on Thursday at the time) I calculated the average Price-Earnings (PE) multiple for the Australian share market at the time had risen to 14.5 – on fiscal 2011 estimates.

The long term average for the Australian share market is 14-15 on present year financial forecasts, not on next year's estimates. That, plus the fact that we were still eight months off from gaining updated insights about FY10 profits explains why I declared at the time that investors had once again taken their enthusiasm a few bridges too far.

We didn't have to wait long before selling pressure started to build, pulling equities down by nearly 10%.

This time around, however, we are two months closer to the end of FY10, but above all we are back at similar heights with increased valuation support. Today, the Australian share market is reflecting an average PE multiple for FY11 of around 13.7 – 0.8 lower than in January.

To put this in perspective: were the Australian share market multiple to rise again to 14.5 (similar to January) and with all else remaining equal, the ASX200 index could potentially rise to 5190.

It is this difference in valuation potential that has been supporting the share market's gradual uptrend since mid-February. Other commentators look at Greece, or at US President Obama's healthcare bill to explain why equities have risen over the past six weeks. I look at underlying valuations, knowing that the past has taught me increasing expectations tend to trigger and stimulate buying support.

That's exactly what has happened over the past month.

The good news is that this process is far from over. The offset is that the psychologically important 5000 level is approaching, and approaching fast.

Will we get through it? Probably not this week, I'd say. But if the monthly rhythm of equity market weakness into the new month repeats itself next week, I'd be inclined to say go, jump on board, because April is likely to see the ASX200 climbing above 5000.

By then, we will be another month closer to the start of FY11 and who knows how many additional expert upgrades further. It is difficult to argue with apparent valuation support.

This is also why I believe that any share market weakness will remain limited in the short term. There's simply too much valuation support for too many blue chip stocks.

Here's one way to illustrate this point: if the Australian share market is trading on 13.7 times the average Price-Earnings ratio for FY11, then how many stocks are actually trading above or below this average multiple?

FNArena's R-Factor (see website) shows 97 out of the ASX200 companies are currently trading on a lower multiple. Upmarket retailer David Jones ((DJS)) is the last one to make the cut, trading on a FY11 PER of 13.66.

If we take into account that nine of the 200 companies cannot be included because of the simple fact there are no consensus data available (yes, it's a small market in Australia) than this equals more than half the index.

The good news is that the half with below average PE-multiples includes all the banks, Big Four and the others, both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), plus the likes of Harvey Norman ((HVN)), QBE Insurance ((QBE)), Fortescue ((FMG)) -yes, you read that one correct- Incitec Pivot ((IPL)), Foster's ((FGL)) and Orica ((ORI)).

Yes, this is a rough measure to assess the market as it doesn't take into account that some stocks deserve a premium while others should trade at a discount, but surely it must be a relief to see so many blue chips, including the banks and the two diversified resources giants still on the cheaper side of the share market?!

And those two resources giants, plus Fortescue, are about to become a big deal cheaper if the latest news from Brazil about this year's iron ore pricing proves accurate.

To avoid all misinterpretations: further upgrades to corporate earnings forecasts are not solely a result of increasing pricing expectations for bulk commodities, or for commodities and energy in general.

Macquarie strategists have just finished redoing their numbers and projections for US corporate earnings and they too have responded with material upgrades. Report the strategists: "The US is undergoing a strong production-led recovery, underpinned by a very large inventory cycle, together with a still cheap currency and strong productivity growth of over 4%."

The key factor in Macquarie's outlook is that the US consumer will not contribute materially to the jump in corporate profits. Nevertheless, earnings per share for US companies are expected to advance by 30% on average this year (calendar 2010) and again by 20% next year.

And that's just one such example.

Just for comparative reasons: earnings per share for Australian companies are currently forecast to improve by some 5%-plus in the fiscal year ending on June 30 (FY10) and by more than 20% in FY11 – these are consensus calculations done by FNArena. No doubt, this difference explains why experts believe the US market will outperform Australia.

The sceptics among you will respond by questioning whether this sudden boost of optimism doesn't smack of the good old "investor exuberance" that regularly creeps into financial markets, usually as foreplay to major disappointments later.

I note, for instance, resources analysts at Barclays issued a report today in which they proclaim we are about to witness the "biggest ever recovery in global base metals demand". Even if this prediction proves accurate, one wonders how many investors will genuinely take this as a given and act accordingly this time around?

Just the fact that all risk assets continue to trade in close correlation with each other, centred around that elusive "risk appetite", should indicate to everyone that just as financial markets are now caught in a self-feeding positive spiral, things could still get ugly if the global winds change direction.

But, as I indicated in stories of past weeks, these are not considerations on Mr Market's present mind.

With these thoughts I leave you all this week.

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

P.S. II – The above mentioned Macquarie market strategists made no secret about what they think lies ahead for global equity markets. The title above their strategy update carries the title "Houston – we have lift off!"

The report also highlights that key stocks in Australia with earnings exposure to the US recovery include cyclicals such as News Corp ((NWS)), James Hardie ((JHX)), Billabong ((BBG)), Incitec Pivot ((IPL)), Computershare ((CPU)) and Brambles ((BXB)), while Australian growth stocks with US exposure include CSL ((CSL)), ResMed ((RMD)), Cochlear ((COH)) and QBE Insurance ((QBE)).

P.S. III – Market strategists at Citi argued this week that the time on the so-called Investment Clock has now shifted to eight o'clock and this means that equities will turn out the best investment option this year. The Citi strategists note "The risk of a double-dip recession has faded and corporate earnings growth has started to come through". They foresee double-digit returns for the year ahead.

P.S. IV – Market strategists at Deutsche Bank have done some extra-work into which sectors and companies in Australia are more leveraged to the economic recovery than others. Their conclusion is that the operating leverage might not be great in areas exposed to household spending, but it continues to look potentially large where business spending is involved. As such, the strategists added Leighton ((LEI)) and Goodman Group ((GMG)) to their Model Portfolio, replacing Crown ((CWN)) and Mirvac ((MGR)).

It is quite extra-ordinary what has been happening over the past few weeks, and I am not referring to the fact that equity markets (outside the US) and commodity prices are approaching new highs for the past twelve or eighteen months.

Risk appetite is back in global financial markets, there can be no doubt about it.

Is it justified? Well, that is what I was referring to in my opening sentence. As more and more economists are updating their projections on the basis of recent insights and indicators, growth projections for 2010 continue moving higher. For the US, for China, for Australia.

The only region that seems to be missing out on this global phenomenon is Europe where austerity measures by the Greek and Spanish governments are just one reason for reduced growth expectations this year.

This flood of constant upgrades is pushing up expectations for corporate profits and this, as I explained in the past, is providing global equity markets with a free bonus on the valuation side.

In other words (and this might seem strange at first sight), share markets have become relatively cheaper (thus more attractive) over the past month, even though they have risen quite strongly since the last bottom in mid-February.

Probably the best way to illustrate this is by making a straight comparison with mid-January when major Australian equity indices were at (more or less) similar levels as they are this week.

In my first editorial of the year on January 18 (still called Rudi on Thursday at the time) I calculated the average Price-Earnings (PE) multiple for the Australian share market at the time had risen to 14.5 – on fiscal 2011 estimates.

The long term average for the Australian share market is 14-15 on present year financial forecasts, not on next year's estimates. That, plus the fact that we were still eight months off from gaining updated insights about FY10 profits explains why I declared at the time that investors had once again taken their enthusiasm a few bridges too far.

We didn't have to wait long before selling pressure started to build, pulling equities down by nearly 10%.

This time around, however, we are two months closer to the end of FY10, but above all we are back at similar heights with increased valuation support. Today, the Australian share market is reflecting an average PE multiple for FY11 of around 13.7 – 0.8 lower than in January.

To put this in perspective: were the Australian share market multiple to rise again to 14.5 (similar to January) and with all else remaining equal, the ASX200 index could potentially rise to 5190.

It is this difference in valuation potential that has been supporting the share market's gradual uptrend since mid-February. Other commentators look at Greece, or at US President Obama's healthcare bill to explain why equities have risen over the past six weeks. I look at underlying valuations, knowing that the past has taught me increasing expectations tend to trigger and stimulate buying support.

That's exactly what has happened over the past month.

The good news is that this process is far from over. The offset is that the psychologically important 5000 level is approaching, and approaching fast.

Will we get through it? Probably not this week, I'd say. But if the monthly rhythm of equity market weakness into the new month repeats itself next week, I'd be inclined to say go, jump on board, because April is likely to see the ASX200 climbing above 5000.

By then, we will be another month closer to the start of FY11 and who knows how many additional expert upgrades further. It is difficult to argue with apparent valuation support.

This is also why I believe that any share market weakness will remain limited in the short term. There's simply too much valuation support for too many blue chip stocks.

Here's one way to illustrate this point: if the Australian share market is trading on 13.7 times the average Price-Earnings ratio for FY11, then how many stocks are actually trading above or below this average multiple?

FNArena's R-Factor (see website) shows 97 out of the ASX200 companies are currently trading on a lower multiple. Upmarket retailer David Jones ((DJS)) is the last one to make the cut, trading on a FY11 PER of 13.66.

If we take into account that nine of the 200 companies cannot be included because of the simple fact there are no consensus data available (yes, it's a small market in Australia) than this equals more than half the index.

The good news is that the half with below average PE-multiples includes all the banks, Big Four and the others, both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), plus the likes of Harvey Norman ((HVN)), QBE Insurance ((QBE)), Fortescue ((FMG)) -yes, you read that one correct- Incitec Pivot ((IPL)), Foster's ((FGL)) and Orica ((ORI)).

Yes, this is a rough measure to assess the market as it doesn't take into account that some stocks deserve a premium while others should trade at a discount, but surely it must be a relief to see so many blue chips, including the banks and the two diversified resources giants still on the cheaper side of the share market?!

And those two resources giants, plus Fortescue, are about to become a big deal cheaper if the latest news from Brazil about this year's iron ore pricing proves accurate.

To avoid all misinterpretations: further upgrades to corporate earnings forecasts are not solely a result of increasing pricing expectations for bulk commodities, or for commodities and energy in general.

Macquarie strategists have just finished redoing their numbers and projections for US corporate earnings and they too have responded with material upgrades. Report the strategists: "The US is undergoing a strong production-led recovery, underpinned by a very large inventory cycle, together with a still cheap currency and strong productivity growth of over 4%."

The key factor in Macquarie's outlook is that the US consumer will not contribute materially to the jump in corporate profits. Nevertheless, earnings per share for US companies are expected to advance by 30% on average this year (calendar 2010) and again by 20% next year.

And that's just one such example.

Just for comparative reasons: earnings per share for Australian companies are currently forecast to improve by some 5%-plus in the fiscal year ending on June 30 (FY10) and by more than 20% in FY11 – these are consensus calculations done by FNArena. No doubt, this difference explains why experts believe the US market will outperform Australia.

The sceptics among you will respond by questioning whether this sudden boost of optimism doesn't smack of the good old "investor exuberance" that regularly creeps into financial markets, usually as foreplay to major disappointments later.

I note, for instance, resources analysts at Barclays issued a report today in which they proclaim we are about to witness the "biggest ever recovery in global base metals demand". Even if this prediction proves accurate, one wonders how many investors will genuinely take this as a given and act accordingly this time around?

Just the fact that all risk assets continue to trade in close correlation with each other, centred around that elusive "risk appetite", should indicate to everyone that just as financial markets are now caught in a self-feeding positive spiral, things could still get ugly if the global winds change direction.

But, as I indicated in stories of past weeks, these are not considerations on Mr Market's present mind.

With these thoughts I leave you all this week.

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

P.S. II – The above mentioned Macquarie market strategists made no secret about what they think lies ahead for global equity markets. The title above their strategy update carries the title "Houston – we have lift off!"

The report also highlights that key stocks in Australia with earnings exposure to the US recovery include cyclicals such as News Corp ((NWS)), James Hardie ((JHX)), Billabong ((BBG)), Incitec Pivot ((IPL)), Computershare ((CPU)) and Brambles ((BXB)), while Australian growth stocks with US exposure include CSL ((CSL)), ResMed ((RMD)), Cochlear ((COH)) and QBE Insurance ((QBE)).

P.S. III – Market strategists at Citi argued this week that the time on the so-called Investment Clock has now shifted to eight o'clock and this means that equities will turn out the best investment option this year. The Citi strategists note "The risk of a double-dip recession has faded and corporate earnings growth has started to come through". They foresee double-digit returns for the year ahead.

P.S. IV – Market strategists at Deutsche Bank have done some extra-work into which sectors and companies in Australia are more leveraged to the economic recovery than others. Their conclusion is that the operating leverage might not be great in areas exposed to household spending, but it continues to look potentially large where business spending is involved. As such, the strategists added Leighton ((LEI)) and Goodman Group ((GMG)) to their Model Portfolio, replacing Crown ((CWN)) and Mirvac ((MGR)).

The Australian share market entered the new calendar year with gusto and with positive momentum, allowing the S&P/ASX200 index to rise to 4950.70 by January 11 (intra-day high 4955.10), after which a decline followed and pulled the index back to 4505.10 by February 9 (intra-day low 4464.90).

If we concentrate on the intra-day peak and trough, instead of the closing index levels, the difference between the January high and the subsequent February low is 9.9%.

One month later, and the index has just managed to rise above the 4800 level again, still 3% short of the previous peak, but well above last month's low.

The question most investors will be asking is: what comes next? The expert commentariat remains heavily divided between those who maintain the index is on its way to test the 4000 level, while others are talking about 5500, and possibly higher.

These differences in market views have once again been highlighted by market strategists at leading stockbrokers in Australia updating their views and projections post the February reporting season.

On one hand we find the likes of Tony Brennan at Deutsche Bank, who believes the ASX200 is on its way to reach 6000 by year-end. On the other hand we find Tim Rocks at Bank of America Merrill Lynch who maintains the index won't be further than 4500 by late December.

In between are the likes of Greg Goodsell at RBS Australia (sees index at 5300 by December), Atul Lele at Credit Suisse (5100) and Paul Brunker at JP Morgan (5000). On Monday, Macquarie strategist Tanya Branwhite and her team updated their views, and while not as bullish as Deutsche Bank, Macquarie's projections still sit toward the top end of the market.

By late February next year, predict Branwhite and co, the ASX200 should be at 5548, representing a total return for investors in excess of 22% of which 4.5% will come in the form of dividends.

What all these index projections have in common though (okay, maybe with the exception of Deutsche Bank) is they suggest the ASX200 may not break out of its current trading range until the second half of this year, at the earliest. From a valuation point of view, this is but a plausible scenario.

To put it very simply: the closer the S&P/ASX200 moves toward the previous peak at 4955.10, the higher the inclination will be for investors to start selling their shares, as many equity valuations will start looking stretched. On the other hand, the closer the index falls to the previous trough below 4500, the more value oriented investors will look into buying again, as they will see true bargain opportunities.

As one stockbroker put it to me two weeks ago: it comes to a point where you feel it is near impossible to not make money if you buy at these levels.

Think Telstra ((TLS)) below $3, for instance.

What are the chances the index will remain in between 4464.90 and 4955.10? And what are the chances the index will ultimately break out of this range; either to the downside or to the upside?

The answer to these questions remains closely tied to what happens to earnings expectations for fiscal 2011. Last year, investors bought shares in anticipation of a normalisation in share market values. This is why those stocks that had fallen the most during the bear market of 2008 have outperformed the more solid and stable companies in the share market. This year, however, investors are looking for value through gains in profits on the back of the global economic recovery.

Growing profits will not only justify last year's jump in Price-Earnings (PE) ratios, it will also create additional value as today's lofty share prices will look relatively cheap on FY11 multiples. Of course, this argument carries more weight when the index is near 4500 than when it is above 4900.

Let's put some numbers behind the theory. The ASX200 above 4800 translates into 16.3 times average earnings per share for fiscal 2010 (consensus forecasts as measured and calculated by FNArena). That's well above the decade average of 14.5, and reason why market bears are constantly complaining about how "expensive" the share market is.

On FY11 projections, however, the Australian share market is still only trading at 13.6 times consensus expectations, and that still leaves further room for appreciation.

Add an extra 100 points to the index and the FY11 market multiple rises to 13.9x, still below the long-term market average, but getting closer and don't forget: FY11 doesn't commence until July this year (though that's drawing closer too).

On current consensus projections, the ASX200 could well rise to around 5117 before we should start using the label "fully valued" on FY11 metrics. But then again, it is a near certainty that earnings forecasts for many cyclical companies will rise further in the weeks and months ahead. Think coal and iron ore companies, for instance.

Many an expert with a longer term horizon will also argue that Australian banks are still available at relatively cheap valuations (and I can only agree).

Here are a few examples of valuations for large cap stocks (they represent the most index weight) on FY11 metrics:

- Rio Tinto ((RIO)) is trading on 10.4x FY11 consensus EPS
- ANZ Bank ((ANZ)) is on 11x FY11 consensus projections
- National Australia Bank ((NAB)) is trading on consensus FY11 PE of 9.6
- Telstra ((TLS)) is valued less than 9 times FY11 consensus EPS
- Qantas ((QAN)) is on a FY11 consensus PE of 11.17
- BHP Billiton ((BHP)) is on 11.16
- Harvey Norman ((HVN)) is on 12.75

As one can see from this short list, many of the index heavyweights are still valued well below the market average for FY11. This supports the view that large caps are poised to outperform small caps in general terms in the year ahead.

This suggests the index can rise further on the back of these large caps stocks closing the valuation gap with their smaller peers, not to mention the potential for further increases to earnings projections for FY11 and beyond. Some resources analysts, for instance, have again started talking about "peak margins" for BHP and Rio Tinto, most probably in FY12.

The problem with all of the above, however, is there is still downside to market estimates and valuations. China's growth target of 8%, for example, looks rather subdued when one considers it was growing at double digits in Q4. And economies worldwide are now slowing down, coming from a strong, stimulus-supported finish to 2009. The latter hasn't received much attention in media and research reports just yet, but I will be digging deeper into this matter later this week (subscribers: stay tuned).

On pure valuation metrics, however, I'd be surprised if the index would fall much below the 4500-level, unless, of course, the current positively-biased economic environment not only weakens noticeably, but reverses into a negative trend instead. This continues to be a real and present danger, even though I am inclined to hold a longer term positive view.

FNArena calculates consensus sentiment, price targets and earnings forecasts on a daily basis for more than 400 Australian listed companies. Subscribers can access these data, via tools and applications such as Stock Analysis and the R-Factor, every day on the FNArena website.

Always tricky to make a prediction on a day when the Australian share market reaches a new five week high (intra-day) and closes higher for the fourth day in a row, but I have a feeling we're on our way to test the levels of early January. If successful, we could see new highs for the year 2010.

Those who have been reading my past analyses know that I keep a close eye on what happens in currency markets. As financial markets continue to be dominated by investor sentiment, what happens between the major currencies has become a key ingredient to determine the direction for financial assets.

That's because all those difficult macro-issues ranging from sovereign debt concerns in Europe, to tightening measures in China and India, to (apparently) less central bank appetite for US Treasuries are instantly translated into changing values between the world's leading currencies.

As such, I believe currency markets have been leading equities and commodities in 2010, and I haven't yet seen a good reason why this would change tomorrow. What has caught my eye is that the USD Index has found it difficult to surge past 81.

There was one quick attempt on the Friday (Oz time) when the Federal Reserve unexpectedly raised the emergency lending costs for US banks, but that didn't even last into the next day. After that we've seen the US dollar rally against the euro, and rally against the British Pound ("Cable"), but the index against the US's five major trading partners has effectively stalled above 80, and below 81.

And one can tell on days when there's only a whisker of the US dollar no longer gaining ground, trigger-ready speculators are overly keen in starting pushing up prices for copper, gold and crude oil, and equities are all too willing to follow in the slipstream.

Note: I am by no means suggesting it's only those evil speculators who are behind February's revival for risk assets. They are simply the first ones to respond and to act. If my information is correct, the present revival among commodities is predominantly the result of funds managers re-entering the space.

It would seem the best case scenario is right now for the USD Index to hold on to its current level, which, in my view, would allow commodities and equities to do what they do best: go higher. If we are talking more bearish scenarios for the US dollar, which are quite frankly more likely if only because FX movements haven't exactly been subtle these past months, then I think we could witness some quick, sharp movements upwards.

After all, and as I have pointed out repeatedly in the past, the first instinct of share markets is to rally higher. So in the absence of anything that keeps a lid on them, that's exactly what share markets will do.

What lies behind future US dollar movements is improving confidence. The same confidence that made the Reserve Bank in Australia announce its fourth cash rate hike in five meetings this week. Do I need to wait until international stockbrokerages such as UBS or Credit Suisse update their Risk Appetite Gauges before I can tell whether global appetite is once again on the rise?

Look around, there's appetite in abundance in March.

The above scenario gains even more credibility since the euro is facing a record number of short positions in the market. Similar to the situation in December last year in the gold market and in January this year with crude oil: when the market is tilted so much into one direction, you can almost bet your money it's going to move into the opposite direction.

In the case of gold and crude oil it was about too many investors being "long", in the case of the euro right now it's the opposite. (Similarly, the USD is now facing a market which is at record highs "long").

And while most in the markets, and in the press, have been wetting their enthusiasm on (mostly) Q4 economic data (which are backward-looking since it's already March), I have been waiting for the February update of the IHS Global Insight-USA Today forward looking economic outlook index.

One can probably tell from what I've written so far that the update did not disappoint. In late January the index indicated economic growth in the US had peaked in Q4 and would gradually trend down towards mid-year.

This was one of my major concerns earlier this year: that we would all get excited on the basis of backward-looking data, and simply ignore that global economic growth (US, Europe, China, Australia) was slowing down coming into 2010.

This concern hasn't completely disappeared, but the IHS Global index has improved a lot over the past month. It now indicates monthly GDP growth in the US should remain above 4% for the first four months this year.

Okay, growth is still expected to weaken to 3%- and 2%-plus after that, but at the very least the IHS index indicates the US economy can potentially support global risk appetite until May or June, which is a long time in today's era of short term horizons and impatience.

Thus while the short term prospects for equity markets have improved, the uncertainty of what comes next is not going to go away any time soon. Remember: one of those other leading forward looking indicators -the ECRI index- continues falling, indicating a "dip" in US growth by mid-year.

Note: this index last year correctly indicated the US economy had bottomed and at some point suggested the US would record 6% growth in the final quarter of the year – in light of the latest Q4 GDP growth revision to 5.9% that was pretty accurate on anyone's view.

Assuming most of the above proves correct, and we will witness a new leg up towards index levels last seen in early January, it doesn't really take a genius to figure out what is likely to happen next. This is because, contrary to last year, this year underlying valuations of assets do count, and very much so.

At current index levels in Australia, the share market is trading on a little below 14 times FY11 forecast earnings per share (the multiple for FY10 is much higher). This includes all recent adjustments made after an overall positive reporting season (though not all changes are incorporated yet) and including the recent upward moves in share prices.

But then, once we start approaching those January levels again, we'll be extending the FY11 multiple to 14.5 and beyond – the historical average for the Australian share market one year in advance (not 16 months in advance).

So depending on how fast we're moving, and how much more upside follows in terms of upgrades to forecasts, I'd be inclined to believe we will get to 5000 once again too early and the market will again look expensive.

I don't have to elaborate any more, do I?

I do hope that if we get back to near January index levels, that we will manage to surge higher, even if it is only intra-day or by one point. Hopefully that'll temper all those technical chartists I see every day predicting there's a new bear market waiting around the corner.

If indices make it above January levels, that would take away at least one argument out of the bearish chartists lexicon.

With these thoughts I leave you all, for now.

But not before I share with you one final advice by investment legend Jeremy Grantham, Chairman of the Board of Boston-based Grantham Mayo Van Otterloo, otherwise known as GMO:

"Remember that you will never catch the low. Sensible value-based investors will always sell too early in bubbles and buy too early in busts. But in return, you may make some important extra money on the roundtrip as well as lowering the average risk exposure.

"Life is simple: if you invest too much too soon you will regret it; "How could you have done this with the economy so bad, the market in free fall, and the history books screaming about overruns?" On the other hand, if you invest too little after talking about handsome potential returns and the market rallies, you deserve to be shot."

One of the China characteristics from the past few years was that the world's new super-power in manufacturing was exporting deflation across the world, leading to ever lower prices for products "Made in China" and a sheer impossibility for manufacturers elsewhere to compete on a like-for-like basis.

That is changing, however, and rather rapidly. China will be battling inflation this year and one of the main drivers behind this change are rising wages. Anecdotal evidence has it that factory owners in the Pearl River Delta are finding it hard to attract labourers, despite offering wage increases of up to 15% versus a year ago.

China's headline inflation number in January looked okay at face value, but few economists would accept this as a blue print for the year ahead. In fact, and as rightly pointed out at the time by China watchers at ANZ Bank, the underlying trend in January is already pointing towards much higher inflation numbers in the months ahead.

At face value China's January CPI grew by 1.5% annualised, down from 1.9% in December, and still well below the central bank's target range of 3-4%. But there are plenty of signals, including the aforementioned wage pressures in factory regions, that suggest authorities better act now.

This is why the reserve requirements for Chinese banks have been increased on the Friday before Chinese new year, signalling Chinese authorities are well aware of the need for decisive actions, and they do understand there is a sense for urgency.

But lifting bank reserve requirements alone won't be enough. As more and more economists are looking into the problems and challenges facing Chinese policy makers this year, there is a growing sense that much more will need to be done.

So what should investors expect? More reserve requirements? We already had two of 0.50% each in both January and February. Will there be a hike in Chinese interest rates? Several hikes? A revaluation of the Chinese renminbi?

Most likely all of the above.

Chances are investors won't have to wait long either. Already the restrictive policy move just before Chinese new year shows the central government is aiming to stay at the forefront of the action curve, keen to contain future problems before they have a chance to grow out of hand, rather than having to play catch up at a later stage.

First, let us briefly return to why Chinese businesses are facing the prospects of rising labour costs. It was always widely assumed, and reported, that China has a sheer endless supply of labour, which is, of course, not true. If anything, China has a relative unfavourable balance in its population, being already skewed towards elderly, especially given the early stage of transition and development the country is in.

In addition, the sharp drop off in export orders during the GFC in combination with higher prices for agricultural products has narrowed the financial gap, and thus the attractiveness, to move out of rural areas back to the cities. This is even more the case since the Chinese government has absorbed a big chunk of job losses through numerous and large infrastructure projects that for many Chinese are closer to their rural roots than the cities.

China is a big country and exact insights are seldom available, even for economists on the ground who spend most of their days deciphering what is happening inside the country. Many of them will be watching the factories closely now the country jumps back into full gear after a week of celebrating.

But rising wages are far from the only threat to Chinese consumer prices. China watchers at Dragonomics, a division of GaveKal dedicated to researching China, reported this week they believe 9 out of 15 CPI components in China are now firmly on the rise.

And those China watchers at ANZ Bank who, earlier this month, were quick in picking up that China had an underlying inflation problem, arguing quick policy-response is a necessity, have now followed up with a special report on China. Their conclusion: if Chinese authorities do not act very soon their economy will start overheating a la the first half of 2008.

That wouldn't be good news as the unsustainable growth rhythm of 13%-plus was followed by a sharp decline into single digits after the Beijing Olympics later that year. No doubt, it is this scenario the Chinese policymakers are trying to avoid this time around.

According to ANZ Bank's proprietary China Activity Index, overall activity levels inside the Chinese economy have already exceeded the aforementioned levels of 2007/first half of 2008. This suggests China risks overheating in the very short term.

This is exactly what ANZ economists are predicting – in the absence of more restrictive policy actions. Enter the US Federal Reserve Bank. One of the immediate responses from economists worldwide after the Fed lifted the discount rate for emergency loans to US banks by 0.25% on Friday was that the move to normalisation would be welcomed by Asian central bankers as they are unlikely to act as long as the US remains in a policy bind.

ANZ highlights there is one important difference between China now and back in 2008. As export markets have remained weak, the Chinese economy is only overheating in the inland provinces, not in the coastal areas that are more export oriented. This is opposite what happened in 2007 and 2008. But then again, it would seem export markets are improving, so the problem will only become worse.

In addition, reasons ANZ, Chinese infrastructure projects will keep commodity prices at elevated levels, which means the country will continue importing inflation.

So far, Chinese authorities have lifted reserve requirements for banks by 100 basis points, in addition to various other restrictions, all aimed at draining excess liquidity out of the banking system. But it won't be sufficient to keep the brakes on inflation, property prices and demand for labour, argues a growing army of economists.

A consensus seems to be forming that more drastic policy-responses are forthcoming, even though not everybody is on the same song sheet when it comes to the exact timing. Will China finally revalue its currency this year?

Economists suspect there will be a one-off large re-adjustment in the USD-peg, which, of course, will take most of the world by surprise. Such a move would probably come in combination with a widening of the RMB trading band against the greenback.

And there will be more restrictions for banks and for property investors. Plus interest rates will have to rise too.

It's probably no coincidence that, given these prospects, the Chinese share market is among the worldwide laggards this year. And commodity markets have already shown sharply increased volatility. Both elements are unlikely to change any time soon as Chinese policy makers will likely have their work cut out for them this year.

Meanwhile, commodity bulls are anxious to find out whether a sharp revaluation of the Chinese currency will translate into more demand as it will effectively make prices cheaper on a relative basis (vis-a-vis USD prices).

Expect more policy actions soon.

This story was originally written and published on Monday, 22 February 2010.

Today I received what I thought was an interesting question from Mark, who's a professional investor working for an asset manager with an international profile in Sydney. I thought I'd share my response with you all this week.

Mark asked me about my thoughts on when financial markets would be ready to leave Greece and sovereign default fears behind and start concentrating on strong company results, both here as in the US?

In line with what I wrote last week, I responded that I think too many people assume Greece is all that is keeping equity markets below the levels seen in early January. This may be true in the very short term, as in: we may see a rally for a day or two whenever there is a positive development in Europe, but is Greece really the only problem investors should be focusing on?

I think the problem in the background, the one that is hardly receiving any attention at the moment, is one of receding economic momentum. In Australia, for example, economists look at the very firm data that continue to come from the local labour market, data that are without any discussion impressive. And consumer spirits seem to remain upbeat, and so are business leaders.

But then again, National Australia Bank's January survey showed an unexpectedly large fall in business conditions. In fact, that fall was so large and out of synch with the overall trend throughout 2009 that some economists labelled it a probable statistical aberration. But as I pointed out last week, other data had been rather weak as well. And today's leading indicator release by Westpac -enormously strong- also suggests the availability for credit overall remains a problem.

Maybe, I suggested earlier today, maybe there is an underlying trend here: maybe indicators for January are somewhat less buoyant than those for December. This would not necessarily be a problem, as long as this doesn't become a new trend. Were the same to happen in economies such as the UK and most of Europe, investors might not be so kind to their equity exposures.

Taken from this perspective, some recent data releases from the UK and Europe have been absolutely dismal. Up to the point where I suspect that share markets haven't responded in a more negative manner because they already had been under the pump because of the Greece-factor. But consider, for instance, that the UK has only managed to put an end to negative GDP growth by the tiniest of all possible margins: 0.1%. One would hope the next revision doesn't slice anything off because that would automatically mean the UK still is in recession (or at zero growth).

And Europe's last GDP figure was effectively saved by France, with the eurozone's Q4 GDP also printing 0.1% growth. This was down from 0.3% in the previous quarter. The big question hanging over Europe now is: what if the next quarter is further down again? It would re-open the public debate about whether the economic recovery is a genuine one, at least in Europe.

Combined, Europe might represent the largest economic entity of our time, but there simply is no discussion: the most important economies remain those in the US and China. This is why the overall response from global financial markets to the problems in Greece and wider Europe has remained relatively muted. But China is tightening and regardless of whether investors like it or not, more tightening is around the corner. Economists at Standard Chartered suggested last week the central bank in China will continue raising the reserve requirements for banks every month this year.

The bulls in the market continue to tell us: it doesn't matter, it is a good thing for the longer term. That is more likely true than not, but the fact remains that for now Chinese authorities are focused on slowing down growth and asset prices, and they will achieve their goal. We have yet to find out how exactly this story will develop in the months ahead, but in its core the China story in 2010 can simply be summarised as: slowing down growth.

And the US? Well, it seems like growth in the US is about to hit some speed bumps too. Last week I reported proprietary leading indicators from IHS Global are indicating US GDP growth is likely to peak in the first months of 2010 and then gradually taper off by mid-year. Since then researchers at the Economic Cycle Research Institute, otherwise known as ECRI, have confirmed this is their view too.

Why do I mention ECRI? Because the Institute is making some big claims (see their website www.businesscycle.com) in that they correctly predicted the recession of 2000 and the subsequent recovery in 2002, as well as the next recession in March 2009 and the subsequent recovery in April last year. I have to also mention that various experts have publicly doubted these claims recently, but this has triggered responses from others, including economists and professional traders in the US, that they made correct decisions, and profits, on the basis of those ECRI predictions.

Now ECRI is forecasting that US growth will experience a pullback around mid-year. The so-called ECRI Weekly Leading Index has been on a gradual decline since late November and is now generating the lowest reading since a year and a half ago.

The message from both IHS Global and ECRI is: expect robust growth in Q1, but beware for the weakness that follows next.

In terms of share market direction, this week may prove to be a very important one. Regardless of the low volumes in February, global equities and commodities have put in some big rallies recently (after seemingly staring into the abyss) and various chartists are turning more positive every day. A term that is commonly used these days is "bear trap" – was the correction between mid-January and mid-February nothing but a bear trap?

If this is the case equity markets and commodities should surge through key technical resistance levels between now and the end of the month. If they do, more and more money will flow into these markets and this in itself should ensure another extension to this week's advances.

The level that is currently on everyone's radar is 10,300 for the Dow Jones Industrial Average and 1100 for the S&P500. If these levels are broken, chartists predict both indices will go hunting for 10,750 and 1150 respectively.

In Australia, the ASX200 managed to surge through technical resistance at 4650 today, and close above it. The next target should be 5000 (again).

These levels have grown significantly in importance since equity indices tried to reach for them in January, and failed. Investors should watch two indicators that are often being watched closely by technical chartists:

1.) will equity indices manage to reach higher than last time? (If not, this should be regarded a bearish signal)
2.) will indices manage to break and close above these resistance levels? (If not, we are experiencing a so-called double top, which is bearish too)
3.) the most bearish scenario is one whereby the rally falls short in making a new high and subsequently retreats below the lows seen in the recent pullback

From a fundamental perspective I see clear support from bargain hunters at the low levels we saw over the past few weeks. But that, however, doesn't tell us anything about what will happen the next time we (might) fall back to these levels again. Were this to happen amidst an overall weakening economic environment, support may not be as ready and forthcoming as it was in this month.

One observation that deserves to be highlighted, in my view, is that currency movements have clearly led risk assets this year and it would appear that what was supporting the US dollar earlier (too many people positioned short) has now switched in favour of the euro (too many people went short from mid-January onwards). As such, the euro was always due for a bounce, which in return allowed equities and commodities to put in strong rallies.

It does, however, put a big question mark over what is really happening in today's markets, and about the sustainability of it all.

Only one way to find out.

I recommend subscribers also read this week's Weekly Insights "How Much Should Investors Pay? "

With these thoughts I leave you all,

Till next week!

Your editor,

Rudi Filapek-Vandyck

(as always firmly supported by the Ab Fab team at FNArena)

P.S. I – The chart below, courtesy of Glushkin Sheff's David Rosenberg, is quite disconcerting, no matter how hard market bulls try to look in another directions. American banks are not lending. Can the US economic recovery be sustained without banks lending?

I have not yet joined the world's doom and gloom forecasters, and I certainly do not have the intention to do so today.

Firstly, I do not believe that the future can be read from price charts. I do not believe the future is set and already determined. Whatever the future might bring will be the net result of all relevant actions and responses between yesterday and then. As such, what we call "the future" is a constantly evolving process.

I don't believe the future can be read from the past either. If the past shows us anything it is that things are always different, even if they repeat themselves. The past also shows us it is far easier to look back and see things coming "in advance" then it is in real time.

Over the past weeks I have been pointing to the fact that trendline after trendline has been broken. In Chinese equities. In oil. In base metals. In many equity indices across the globe. In FX crosses (especially those involving the yen, the USD and the Aussie). In all major commodity indices.

Surely, anyone with an inquisitive mind will have asked by now: what exactly is happening?

A trend has come to an end. This has been my conclusion for the past three weeks and I certainly have seen no reason to change my conclusion. But is it the end of the uptrend, in other words: are we heading back to where we left it in March last year?

I don't know.

I do know that similar events from the past show us that all the above mentioned assets, crosses and indices are now likely to struggle for a while, and this struggle can manifest itself in various forms: increased volatility with no net gains, side-ways movement or a new, opposite trend.

The latter could be very disappointing because, as equities and commodities were enjoying a pronounced uptrend, this would mean the opposite will be happening from now on.

Taken from a positive point of view: it could be argued that equities and crude oil have effectively been sideways-tracking since late September last year. This makes February potentially the fifth month in a row.

Back in 2003, as I have pointed out earlier, the sidetracking prior to the trend line breach only lasted for about a month, but it then lasted for nine more months after the event.

In 2007-2008 however, there was no sideways movement, that was pure carnage.

So what makes 2003 so different from that latter experience? Simple. The first one was followed up by the next bull market. The second was not.

To put it in another way: in the first case economies re-established themselves, started growing strongly and allowed demand for commodities, for products and for services to grow strongly too. Company profits followed suit, and thus share prices did so too.

In the second version everything opposite happened. No wonder share prices and prices for commodities went down.

As I pointed out in my Weekly Insights analysis this week, the same happened in 1994, when, after a strong rally in the year prior, equities and commodities peaked in January – and they never even came close to those peak levels again for the next twelve months.

Back then economies stumbled temporarily, as one would expect coming out of a severe crisis, but they continued recovering and ultimately became strong and healthy again. Thus from 1995 onwards everything went up again.

Conclusion number one: when viewed from a broader perspective, 1994 was merely a dip, a pause, a year of consolidation in a longer term uptrend. And so was 2003/04.

Problem: most investors observe and experience financial markets from a micro-perspective.

Conclusion number two: clearly, financial markets are not always following the direction of the global economy, this despite most financial experts basing their views on the global economy.

Question: what could be more important and more dominating than the recovery of the global economy?

Try the health of the financial system. Global liquidity. Future policies and regulations. These are all factors that have captured news headlines, and investors' angst, from mid-January onwards.

Yet, despite all these grave concerns (and I haven't even mentioned the increasing tensions between the Obama administration and China) there could be a far more simpler explanation as to why 2010 might become more of a repeat of 1994.

Market strategists at Citi in Hong Kong, Markus Rosgen and Elaine Chu, always had an inclination that year number two after an economic downturn is likely more of a subdued event – this contrary to widespread assumption that year two is still a very good one for investors. Now Rosgen and Chu have done some historical analysis, which in essence has proved their gut feel correct.

The term we are looking for is: PE contraction.

The analysis conducted by Rosgen and Chu shows that a typical scenario after the downturn is for share markets to rise strongly on rising Price-Earnings Ratios as profits are still low, but investors are hopeful these profits will rise at a later stage. In Year Two, however, higher profits do manifest themselves, but PERs fall back to lower levels.

It doesn't take too much imagination to see that this negative change in PERs becomes a headwind, even with rising profits.

This does not mean that 2010 will by default generate a negative return for equity markets (as happened in 1994). It does mean however, that returns will be a lot less than growth in profits might indicate.

If you're looking for reasons why PERs contract in the second year I'd say it probably has to do with the fact that by then concrete numbers start replacing hope and expectations. This is bound to put a dent in overall enthusiasm, plus central bankers are by then looking to shift into tightening mode which always puts a lid on too much exuberance too, if not through a less-accommodative bond market.

In 1994 the bond market turned into the evil-doer.

Citi's analysis, which I am prepared to adopt myself, fits in with the macro-views at GaveKal, where market strategists this week reminded investors that bull markets typically progress in three phases:

1.) in phase one everything goes up. No really, especially the lower quality assets ("junk") – they outperform the quality ones.
2.) in phase two markets tend to gravitate to where the growth drivers are
3.) in phase three the focus shifts towards cheap assets and value play

We should be in phase two now, but, interestingly, remarks GaveKal, on the basis of recent market movements one would be inclined to think these growth drivers are "Western brands" more so than emerging markets or commodities. GaveKal likes Western brands as they represent "growth" while trading at historically cheap valuations.

First, however, we are going to see a decisive battle between the bulls and the bears in the market – between those investors who cannot believe they managed to fetch some extra BHP Billiton ((BHP)) shares below $40 this week, and those who believe they will be able to buy some at lower prices in a while from now.

Who's going to get the upper hand?

My bet is on the bears. Firstly because we had too much exuberance in late December-early January and that always takes a while longer to completely play out. I believe, for example, that base metals, and copper in particular, still have struggles left and oil's best hope would seem to be further range-trading, for now. But also because many observant market watchers are pointing at weak underlying equity market dynamics, and not just in Australia.

The number of stocks rising is gradually being outnumbered by the number of decliners. Market volumes during up days (like Tuesday and Wednesday in Australia) are much, much lower than on down days. This has traditionally always been a warning signal.

In addition, I don't think portfolio-readjustments across the globe have run their course just yet. Remember, last year every investor and his grandmother went short US dollar and long risk assets. This year's process of re-adjustment is not over yet.

There are still plenty of technical chartists out there who warn about weak internals, broken support levels and lower targets that will be put to a test.

Some market watchers have pointed at the decline in overall liquidity as an explanation for the general retreat in investor risk appetite last month. Analysts at GaveKal however, have measured that overall velocity is back into negative territory again. Market analysts with an international spectrum report upgrades to earnings growth are petering out across the globe.

Above all, we are likely to see some dodgy economic news coming through, because China and India are stepping on the brakes and we are still in a particularly vulnerable and volatile phase of the economic recovery.

Consider, for example, the following admission I picked up from Obama advisor Larry Summers at Davos last week: the US is experiencing a "statistical recovery and a human recession".

My best advice is thus: follow the footsteps of the RBA this week; gentle and cautious, while observing what is yet to come, is probably best at this point in time.

As long as the optimists and the value-seekers don't give up, we'll see plenty of rallies after the selling.

With these thoughts I leave you all,

Till next week!

Rudi Filapek-Vandyck

your editor

(as always firmly supported by the Ab Fab Team at FNArena)

I have not yet joined the world's doom and gloom forecasters, and I certainly do not have the intention to do so today.

Firstly, I do not believe that the future can be read from price charts. I do not believe the future is set and already determined. Whatever the future might bring will be the net result of all relevant actions and responses between yesterday and then. As such, what we call "the future" is a constantly evolving process.

I don't believe the future can be read from the past either. If the past shows us anything it is that things are always different, even if they repeat themselves. The past also shows us it is far easier to look back and see things coming "in advance" then it is in real time.

Over the past weeks I have been pointing to the fact that trendline after trendline has been broken. In Chinese equities. In oil. In base metals. In many equity indices across the globe. In FX crosses (especially those involving the yen, the USD and the Aussie). In all major commodity indices.

Surely, anyone with an inquisitive mind will have asked by now: what exactly is happening?

A trend has come to an end. This has been my conclusion for the past three weeks and I certainly have seen no reason to change my conclusion. But is it the end of the uptrend, in other words: are we heading back to where we left it in March last year?

I don't know.

I do know that similar events from the past show us that all the above mentioned assets, crosses and indices are now likely to struggle for a while, and this struggle can manifest itself in various forms: increased volatility with no net gains, side-ways movement or a new, opposite trend.

The latter could be very disappointing because, as equities and commodities were enjoying a pronounced uptrend, this would mean the opposite will be happening from now on.

Taken from a positive point of view: it could be argued that equities and crude oil have effectively been sideways-tracking since late September last year. This makes February potentially the fifth month in a row.

Back in 2003, as I have pointed out earlier, the sidetracking prior to the trend line breach only lasted for about a month, but it then lasted for nine more months after the event.

In 2007-2008 however, there was no sideways movement, that was pure carnage.

So what makes 2003 so different from that latter experience? Simple. The first one was followed up by the next bull market. The second was not.

To put it in another way: in the first case economies re-established themselves, started growing strongly and allowed demand for commodities, for products and for services to grow strongly too. Company profits followed suit, and thus share prices did so too.

In the second version everything opposite happened. No wonder share prices and prices for commodities went down.

As I pointed out in my Weekly Insights analysis this week, the same happened in 1994, when, after a strong rally in the year prior, equities and commodities peaked in January – and they never even came close to those peak levels again for the next twelve months.

Back then economies stumbled temporarily, as one would expect coming out of a severe crisis, but they continued recovering and ultimately became strong and healthy again. Thus from 1995 onwards everything went up again.

Conclusion number one: when viewed from a broader perspective, 1994 was merely a dip, a pause, a year of consolidation in a longer term uptrend. And so was 2003/04.

Problem: most investors observe and experience financial markets from a micro-perspective.

Conclusion number two: clearly, financial markets are not always following the direction of the global economy, this despite most financial experts basing their views on the global economy.

Question: what could be more important and more dominating than the recovery of the global economy?

Try the health of the financial system. Global liquidity. Future policies and regulations. These are all factors that have captured news headlines, and investors' angst, from mid-January onwards.

Yet, despite all these grave concerns (and I haven't even mentioned the increasing tensions between the Obama administration and China) there could be a far more simpler explanation as to why 2010 might become more of a repeat of 1994.

Market strategists at Citi in Hong Kong, Markus Rosgen and Elaine Chu, always had an inclination that year number two after an economic downturn is likely more of a subdued event – this contrary to widespread assumption that year two is still a very good one for investors. Now Rosgen and Chu have done some historical analysis, which in essence has proved their gut feel correct.

The term we are looking for is: PE contraction.

The analysis conducted by Rosgen and Chu shows that a typical scenario after the downturn is for share markets to rise strongly on rising Price-Earnings Ratios as profits are still low, but investors are hopeful these profits will rise at a later stage. In Year Two, however, higher profits do manifest themselves, but PERs fall back to lower levels.

It doesn't take too much imagination to see that this negative change in PERs becomes a headwind, even with rising profits.

This does not mean that 2010 will by default generate a negative return for equity markets (as happened in 1994). It does mean however, that returns will be a lot less than growth in profits might indicate.

If you're looking for reasons why PERs contract in the second year I'd say it probably has to do with the fact that by then concrete numbers start replacing hope and expectations. This is bound to put a dent in overall enthusiasm, plus central bankers are by then looking to shift into tightening mode which always puts a lid on too much exuberance too, if not through a less-accommodative bond market.

In 1994 the bond market turned into the evil-doer.

Citi's analysis, which I am prepared to adopt myself, fits in with the macro-views at GaveKal, where market strategists this week reminded investors that bull markets typically progress in three phases:

1.) in phase one everything goes up. No really, especially the lower quality assets ("junk") – they outperform the quality ones.
2.) in phase two markets tend to gravitate to where the growth drivers are
3.) in phase three the focus shifts towards cheap assets and value play

We should be in phase two now, but, interestingly, remarks GaveKal, on the basis of recent market movements one would be inclined to think these growth drivers are "Western brands" more so than emerging markets or commodities. GaveKal likes Western brands as they represent "growth" while trading at historically cheap valuations.

First, however, we are going to see a decisive battle between the bulls and the bears in the market – between those investors who cannot believe they managed to fetch some extra BHP Billiton ((BHP)) shares below $40 this week, and those who believe they will be able to buy some at lower prices in a while from now.

Who's going to get the upper hand?

My bet is on the bears. Firstly because we had too much exuberance in late December-early January and that always takes a while longer to completely play out. I believe, for example, that base metals, and copper in particular, still have struggles left and oil's best hope would seem to be further range-trading, for now. But also because many observant market watchers are pointing at weak underlying equity market dynamics, and not just in Australia.

The number of stocks rising is gradually being outnumbered by the number of decliners. Market volumes during up days (like Tuesday and Wednesday in Australia) are much, much lower than on down days. This has traditionally always been a warning signal.

In addition, I don't think portfolio-readjustments across the globe have run their course just yet. Remember, last year every investor and his grandmother went short US dollar and long risk assets. This year's process of re-adjustment is not over yet.

There are still plenty of technical chartists out there who warn about weak internals, broken support levels and lower targets that will be put to a test.

Some market watchers have pointed at the decline in overall liquidity as an explanation for the general retreat in investor risk appetite last month. Analysts at GaveKal however, have measured that overall velocity is back into negative territory again. Market analysts with an international spectrum report upgrades to earnings growth are petering out across the globe.

Above all, we are likely to see some dodgy economic news coming through, because China and India are stepping on the brakes and we are still in a particularly vulnerable and volatile phase of the economic recovery.

Consider, for example, the following admission I picked up from Obama advisor Larry Summers at Davos last week: the US is experiencing a "statistical recovery and a human recession".

My best advice is thus: follow the footsteps of the RBA this week; gentle and cautious, while observing what is yet to come, is probably best at this point in time.

As long as the optimists and the value-seekers don't give up, we'll see plenty of rallies after the selling.

With these thoughts I leave you all,

Till next week!

Rudi Filapek-Vandyck

your editor

(as always firmly supported by the Ab Fab Team at FNArena)