Energy/Materials

Responding to a comment on my previous argument against Cash for Clunkers, I feel it's important to highlight that building new cars from scratch consumes energy. A commenter wrote:

 Sometimes "professional" investment research resembles little more than a day trader rag with nicer charts and fancier wording to make the reader feel less guilty and more professional about the kind of "investing" he or she is actually performing. Thus we point to Goldman's recent China "Portfolio Strategy" dated July 31st where they tell us to basically keep buying the Chinese market based on government support for the economy and a "favorable liquidity setup". We're told to buy on dips, "stay engaged" (ie. keep generating commissions), and trade earnings suprises. Is this professional investing or what your college roommate was doing during the dotcom bubble? It's hard to tell the difference.

Market view: Stay invested; buy on dips for new money A-share market gained 12.4% in July despite a 5.3% correction, which was provoked by concerns regarding credit tightening, on July 29. We maintain our positive market view on A shares and think the government’s pro-growth policy stance, which should ultimately lead to macro/earnings recovery and a favorable liquidity setup, will continue to bode well for equities.That said, we see price volatility nudging higher as uncertainties revolving around interim earnings and the government’s monetary policy stance intersect with an above-mid-cycle multiple (24x). We would stay engaged in the market and look for opportunities to accumulate positions on dips.

Strategies: Domestic demand exposure; Trade earnings surprises We recommend investors to focus on the following themes to gain exposure to the A-share market: (1) Laggards with valuation buffers and reasonable EPS growth; (2) Pro-cyclical domestic demand, which includes banks, insurance, property, and selected consumer and materials names; (3) Stocks that are potentially subject to positive earnings surprises.

That's the front page: trust the government to support the market, trust dumber investors to follow you (liquidity) and try to make little earnings trades hoping for pops. Oh wait. What about valuations?

Valuations: Above mid-cycle, but may persist CSI300 is now trading at around 23.9x I/B/E/S consensus P/E and 3.2X P/B on a 12-month forward basis against an average of 18.9x and 2.0x since April 2005, respectively (see Exhibits 1 and 2). On the basis that FY09 EPS growth for the aggregate market could be lower than the 15% that I/B/E/S consensus is currently forecasting, the forward P/E for CSI300 would be even higher at around 26.6x using our FY09 EPS growth assumption of - 5%. July 31, 2009

So valuations are sky high and earnings estimates might be missed. But we should hang on, because high valuations may persist. That's our upside investment case. High valuations may persist... and actually need to go higher or have upside earnings surprises to really give us upside on stock prices since they are already stretched as it is. Also, note that they compare recent valuation multiples to the average since... only 2005.. which was still a pretty bullish period for Chinese equities. So valuations are stretched even above what we saw during a pretty bullish time for China, but we should just have confidence in the government and liquidity to keep pushing things higher. This is what we are made to believe is "professional investing" rather than a gambler's punting.

June data appears to have put Chinese steel utilization at over 90% as per Goldman's recent "Ten drivers for sweet spot" piece. Steel prices have indeed been on the rise over the last 15 weeks partly driven by infrastructure capex being up 49% YoY in 1H09 as per the piece. Overall they expect China steel demand to end up flat for 2009, vs. some previous expectations for a slight decline YoY. Great, Chinese stimulus is boosting near term steel demand. Each steel stock in particular needs its own examination, but broadly speaking, stock price levels that are equivalent to 2007 levels or higher are highly dependent on Chinese government action. They are not value buys, they are let's chase- the-Chinese-government buys. Steel producer EV/EBITDA's look to be about $1,000/ton in Asia, $1,600 in Europe & Latin America, and $1,200 in the US.

Has hope returned a bit too fast to Asian markets? To answer this question, Citi Investment Research's Asia Ex-Japan strategist Mr. Markus Rosgen put out a piece that asks some tough questions of current Asian market bulls, warning that the risk of missing 2009 earnings expectations is high. ("V-Shaped Recovery Priced In; Companies Had Better Deliver".)

Simply put, in Asia, analyst estimates have been revised substantially as of late. So much that 2009 EPS growth is now set at -2%, which is essentially asking for flat year. On this Mr. Rosgen puts forth an interesting point. If these analysts' estimates turn out to be correct, then the current downturn would have seen only one year of substantial earnings decline, in 2008. We would then have a sharp V-shaped recovery... so much that current estimates are projecting 30% earnings growith in 2010. Thus analysts as a whole are saying 2008 was 30% down (historical fact), then we're flat in 2009, then running back to 30% growth in 2010? Hmmm. Maybe. I hope so. But definitely seems like a challenging set of expectations for Asian listed companies going forward. This would make it the "shortest and shallowest" recession since 1975. From an ROE perspective, it would also be doing pretty well vs. history. Analyst estimates have ROE for Asia troughing at 9.3% vs. 4.7% during the last downturn in 1998. What this means is that if Asian bulls turn out correct, then this will truly be an extraordinary recovery from one of the worst global slow-downs to date. Seems like the kind of speculation where the facts and history are stacked against you...

Given where revisions are today, though, the probability of disappointment is much higher than the probability of a positive surprise. Now, analysts are projecting a mere 2% decline in earnings for 09, followed by a 30% increase in 2010. On this view, the recovery is V-shaped. To labour the point, that's a 30% decline in earnings in 2008, essentially flat in 09 and a 30% increase in 2010. Great if it happens. But how realistic is it? And what needs to happen for it to be achieved?