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Market underpins resources sector
Vic De Klerk
Posted: Mon, 19 Mar 2007

[miningmx.com] -- THE world economy is in good shape. That was the iteration of commentators on CNBC's financial news channel earlier this month. A freak event, as The Economist described the sudden 8.8% fall in share prices on the Chinese market in a single day, is certainly not enough to cause a world recession, as some graph experts and forecasters on that financial channel would like us believe.

The Economist even started to speculate whether the instability on world stock markets wasn't perhaps a seven-day wonder.

But whatever the future holds, one thing is certain: investors and speculators take fright easier and become more worried these days. On Wall Street there was so much fear, and the selling orders were so large, that this huge market's enormous computers couldn't cope.

Investors in South Africa also took fright. Long-term investors, who should actually be on holiday at the seaside, suddenly started looking at the state of their portfolios every few minutes. Short-term speculators, usually those who thrive on falls in the market, also called bears, had a lot to say for themselves, as usual, which made it difficult to distinguish between depression, recession or correction in the midst of all the noise last week.
Depression, recession or correction?

That's when investors, whether short- or long-term ones and whether they've got strong nerves or not, should again look at the fundamentals of shares and the traditional principles of value.

The combined graph shows that the price:earnings (p:e) ratio of the all-share index over the past two weeks has been adapted from a somewhat overvalued almost 18 to nearly 15. That's a dramatic fall and compares with the adjustments that will usually occur during a small bear market or declining phase in share prices over a period of six to 12 months.

The p:e simply measures the relative value of shares. The share price is divided by the company's profit per share. This ratio, which was still at 18 a few weeks ago, simply says that local investors were prepared at that time to buy shares at an average of 18 times the current profit. When investors start becoming jittery, they buy fewer years' profit, and that's why the p:e falls to for example the present 15.

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However, this fall wasn't only as a result of the fall in share prices. The largest components in the index, such as BHP Billiton, Anglo American, Anglo Platinum and Impala Platinum, all declared huge profits, and the divisor in the p:e suddenly became much larger, which caused a fall in the p:e.

This makes a bit of fun of all the prophets of doom who were still wanting to warn us a few weeks ago that our shares are too expensive because the p:e of 18 was much higher than our average. It was even higher than that of more developed regions. Remember in such cases to use the 12-month forward p:e.

On the graph, the three periods are indicated where the p:e of the all-share index fell sharply, so much so that it can be described as a significant correction.

On the top graph, which shows the course of the all-share index, which has doubled over the past two years, these three corrections are just blips, and The Economist's report of a seven-day wonder starts looking accurate.

The first major correction or fall in the p:e between February and April 2005 was caused when new Federal Reserve chairman Ben Bernanke, the successor to the divinity of Alan Greenspan, opened his mouth too widely and predicted that US interest rates could rise further.

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Stock markets didn't like that and the Dow Jones dropped by nearly 1,000. We also took fright and sold shares. Pity. It wasn't long before our all-share index climbed by about 75% - between May 2005 and May 2006.

The second event that caused the stock markets to take fright recently was the sudden fall in the prices of commodities - led by copper - after rumours of a major levelling off in China's demand for resources. This correction was pretty sharp. The Dow Jones again dropped by nearly 1,000 points, but locally there was mayhem among the share prices of our financial shares and of the retailers who sell on credit.

Only two months later - that's just slightly longer than The Economist's seven-day wonder - our share prices started climbing again, and before the 2006 New Year's Eve parties there was a 50% profit to be made.

Now we have another such event. The p:e has already fallen sharply, but not yet as low as in 2005 and 2006. Sustained profit growth over the next six months - which has already been earned by the companies and only has to be declared - is enough to push the p:e down to near to 14 by August if share prices don't rise.

However, if our share prices were to rise by about 5%-10%, the p:e of the all-share index will be a good deal lower than 14 by August. That's cheap, and it looks as if the opportunities of 2005 and 2006 could soon be repeated.

The lesson: look at values like future profit growth and forward p:e. And remember, the world economy is in good shape, and so is ours. A sudden fall in share prices on the extremely speculative and unregulated Chinese stock exchange is really just a tail trying to wag the dog.