Having fallen 10 per cent since its April highs, the share market does look decidedly cheap. Admittedly, some of this downturn can be attributed to unusually high tax-loss selling before the end of what’s been a pretty dismal year for shares.

But with further downward pressure expected courtesy of a high Aussie dollar, two possible RBA rate rises later this year – plus worries about Greece, and slowdowns in the US and China – a sustainable correction any time soon looks unlikely. Also adding to an already weakening operating environment is deteriorating consumer confidence which fell to its lowest point in June amid renewed carbon tax fears. In the March quarter, consumers saved 11.5 per cent of their disposable income – the highest rate in 25 years.

Based on historical data, there’s a 76 per cent probability that the All Ords Index will rise in July. However, the typically weak September quarter is drawing nearer, and most analysts expect the ASX 200 to struggle to get back above 4500 year’s end. While strong commodity prices have incubated the resources sector from some of the pain so far, the same cannot be said for many other sectors, especially those with cash flows directly exposed to a particularly fragile business cycle.

Analysts are less optimistic about the market’s ability to deliver the robust earnings recovery initially forecast for 2012. Adding to their woes, many stocks face sizable debt maturities in 2012. According to Macquarie’s research, free-to-invest cash flow – which strips out interest, dividends, CAPEX and maintenance costs – is set to fall to its lowest levels since 2009. This has fuelled concerns that a weaker earnings environment could place renewed pressure on stocks with already low interest cover ratios – with further debt raisings diluting shareholder value. This could potentially undermine balance sheets that most corporates worked so hard to deleverage following the GFC.

While the market clearly presents value opportunities, Kien Trinh quant analyst with Patersons Securities says investors are reluctant to commit until myriad short-term, structural and cyclical issues play out. Based on his analysis, stocks that are most vulnerable to weakness include: Brambles Ltd (BXB), Perpetual Ltd (PPT), Platinum Asset Management (PTM), Boart Longyear (BLY), Sandfire Resources (SFR), Worley Parsons (WOR), Linc Energy (LNC), Cudeco Ltd (CDU), Panoramic Resources (PAN) and Cabcharge Australia (CAB). “Momentum indicators show that these stocks are overbought, and are vulnerable to a price fall in the short-term,” says Kien.

He says oversold stocks that can reap significant short-term opportunities if bought at the right time include: Qantas (QAN), Caltex (CTX), and Fleetwood Corporation (FWD).

Given how much the market has fallen, Kien says the trick for investors sitting patiently on the sidelines is separating stocks now displaying ‘deep pockets of value’ from those that have been discounted for good reason. Within the current trading environment he recommends investors stick with stocks that have shown resistance to the earnings downgrade cycle – notably banks and mining stocks.

Currently losing earnings momentum, Kien Trinh recommends investors avoid the following stocks for now: Leighton Holdings (LEI), Aristocrat Leisure (ALL), Transpacific Industries (TPI), Macquarie Group (MQG), Hills Holdings (HIL), Sims Metals Management (SGM), James Hardie Industries (JHX), QBE Insurance Group (QBE), BHP Billiton (BHP), Pacific Brands (PBG), and SMS.

At face value, the market may look inexpensive, but Matthew Kidman portfolio manager Wilson Asset Management reminds investors that this may not be the case once a pending wave of downward earnings adjustments is priced in next reporting season.

Companies already hit by reduced downgrades include, Energy Resources (ERA), Paladin (PDN), Elders (ELD), Ten (TEN), Pacific Brands (PBG), FKP (FKP), Wesfarmers (WES), SMS Group (SMG), QBE (QBE) – plus Woodside (WPL) and Caltex (CTX) with earnings forecast changes of -30.50 per cent and -20.40 per cent respectively. Other stocks early out of starting blocks with profit warnings include: Newcrest (NCM), Rio Tinto (RIO), Aquila Resources (AQA), BHP Billiton (BHP), and Nufarm (NUF).

Like it or not, Kidman says it’s conceivable that the market could hit 3400 points before finishing the year somewhere between 4000-4500 points, and then bounce lower in 2012. “Unless interest rates are cut, Australia is going to head into recession if it’s not already there,” says Kidman. “Within the current secular bear market, we’re not going to get any decent returns for quite a while.”

Unsurprisingly, fund managers are also sidelining equities with Pengana Capital’s Australian Equities Core Fund holding 25 per cent in cash, while Wilson Asset Management has a whopping 60 per cent of its WAM Active Fund parked in the ‘folding-stuff.’

Without doubt, Kidman says it’s the big cyclicals – notably in retail, transport, housing, media, plus steel and building materials which have suffered earnings revisions of around 50 per cent and 30 per cent in the last 12 months – that are most likely to disappoint. He expects banks, also caught in the market downdraft to experience further pain.

With delinquencies amongst home/business borrowers, and higher bad debts on the rise, TS Lim banking analyst with Southern Cross Equities has cut earnings estimates for the big four banks by between one and four per cent for 2012/13. He’s also reduced Commonwealth Bank (CBA) and Westpac’s stock rating to hold and reduce, respectively.

Given that many stocks – like Bluescope Steel (BSL), Tabcorp Holdings (TAH), Onesteel (OST), Paladin Energy (PDN), and Billabong (BBG) – have already experienced losses greater than 28 per cent, Kidman says there may only be another 5 to 10 per cent drop before they reach bottom.

Like Lim, Kidman also expects the banking sector to deteriorate, but he says it’s the over-valued mid to upper-tier mining/drilling and mining-related stocks – which typically take their lumps later in the cycle – that could see their prices significantly fall away later this year. “It’s conceivable that stocks like Iluka (ILU) and Incitec Pivot (IPL) could experience earnings downgrades of up to 40 per cent,” says Kidman.

At the big end of town, he expects both cyclical and systemic downward pressure on Worley Parsons (WOR), Newcrest Mining (NCM), Woodside Petroleum (WPL), Westfield Group (WDC), Fortescue Metals Group (FMG), and Macquarie Bank (MBL). “Given where the market is heading, investors want to be in defensives food and alcohol stocks and, Crown Ltd (CWN) and Metcash Ltd (MTS) are cases in point,” says Kidman.

Based on a three to six month investment time frame – RBS Morgans recommend numerous rotations to what it calls its ‘high conviction calls’ – where the favoured stock (long) within a sector is purchased with the former favoured stock serving as the (short) funding source. Noteworthy examples include: Selling Energy Resources (ERA) to buy Fortescue Metals Group (FMG), selling Aquila (AQA) to buy Alkane Resources (ALK), selling Ten Network (TEN) to buy Austar United (AUN), and selling Telecom Corp (TEL) to buy Telstra (TLS).

High conviction calls

Sector Preferred exposure Long Funding source
Infrastructure MAP Airports Connect East Group
Banking ANZ CBA
Capital Goods Downer EDI Worley Parsons
Transportation Qantas QR National
Energy Origin Santos
Food & Bev Coca Cola Amatil Goodman Fielder
Healthcare Sonic Healthcare Cochlear
Insurance/div fin AMP Ltd ASX
Materials large-cap Fortescue Metals  ERA
Materials small-cap Alkane Resources Aquila Resources
Materials steel BlueScope Steel OneSteel
Basic materials Amcor Boral Ltd
Media Austar Ten Network Holdings
Retail JB Hi-Fi Metcash
Telcos Telstra Telecom Corp
Utilities Origin AGL Energy
Small-caps – cyclical Skilled Group Hills Industries
Small-caps – defensive SAI Global Tassal Group


Source: Patersons Securities

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