Your LPAC studies aim to inject some rationality into the valuation and use of Australian listed shares and investments, with the emphasis on a longer term investment horizon suitable for financial advisers and their clients. Since our media serves us so poorly on this front, especially in times of stress, we set out below some important analytics that reflect the key methodologies in the LPAC program.

For your convenience you can view my video which covers this material.

Please note that since this video was produced the RBA has now held its August meeting and confirmed the view we take in the following analysis, that Australian rates will fall; in my view this will be a catalyst for the re-rating of the Australian market. This reflects the importance of the "top down" to valuation of shares and other listed investments. Also, since filming, the new Westpac SPS distribution rate has been set at a margin of 2.3% above the prevailing bank bill rates.

In the last quarter Australian and international share markets have repeated the falls of January this year, due to the financial instability triggered by the sub prime crisis, compounded by aggressive hedge fund short selling and extensive margin calls, and global inflation and growth worries. Although these drivers of instability are real, in our view these concerns have largely been over-emphasised by the market and media.

As we show below in our detailed market commentary, the Australian market is now priced at and trading well below fair value, and will recover from these levels. Specifically we show that:

1. Australian inflation and interest rate concerns are starting to abate with the market now pricing in a 50% probability of an interest rate cut, following moderating CPI data and in recognition of the recent comments made by RBA Governor Glenn Stevens which express the RBA view that inflation is coming under control;
2. The Chinese "supercycle" which is the engine of a large component of global growth (and which is also driving demand for Australian commodities) is, contrary to media speculation, largely resilient to a fall in demand from the US and Europe – hard data shows that this US and European demand accounts for only 2% of China's GDP and that the dominant portion of China's GDP growth is driven by demand from China's major Asian trading partners and by rising internal consumption;
3. Inflation worries in China are also overdone, with the observable inflation fighting stance from Chinese monetary authorities giving clear evidence of their determination to promote conditions favourable to continued economic growth;
4. Fears of a systemic failure in the US and/or global financial system are naïve and the repeated intervention from the US Fed Reserve makes it clear that they will not allow a US bank or investment bank to fail. Australian banks have all successfully completed Tier 1 capital raisings in the last quarter and have very strong balance sheets as a result;
5. Oil prices may remain relatively high during the US hurricane season but have already shown signs of abating as the US and European economic slowdown reduces demand. Although China and India will continue to grow their consumption of oil, the massive spikes of this year will be less problematic as the global economy slows and as major new oil fields are opened up: eg Brazil which has announced a confirmed new oil field which has increased Brazilian reserves to levels equal to the massive deposits in Russia;
6. Increased regulatory scrutiny of the market manipulation practiced by hedge funds has led to severe restrictions on naked short selling in the US and Australian regulators are also actively tracking short sellers although not with the same vigour as their US counterparties.

While the Australian market will remain volatile in coming months, the reasoned conclusion we draw from this fundamental analysis is that share prices on the ASX will recover and that quality blue chip stocks are great value at current levels.

Stockmarkets do recover from falls of the sort we have experienced in the last 12 months. Patient investors know that buying stocks at good values, based on a sound understanding of their economic fundamentals, is a key part of long term wealth creation.

By any objective measure Australia is the land of milk and honey, exporting commodities that are the envy of the rest of the world. Australia is to commodity production what the Middle East is to oil supply: we dominate the production of most key commodities, whose scarcity value ensures rising prices over time. Our hard commodities power the industrialised economies and our soft commodities are rocketing in value as global economic expansion and changing affluence drives demand for food. It's not necessary to list here all the virtues of the Australian economy but we should remember that in many other key aspects of a modern economy we operate at world best practice levels, including in relation to the integrity of our banking system.

So why then has our stock market fallen so far, so fast? Should we believe, as some irresponsible media commentators are suggesting, that we are approaching the use by date of modern market capitalism?

In our view the significance of the problems facing the Australian economy and stockmarket have been over emphasised and that, as a consequence, economic growth and stockmarket prices will prove to be far more resilient than the sceptics suggest.

Make no mistake – the sub prime crisis is very simply the unwinding of an old fashioned asset price bubble. Just like the tech wreck in 2001 which followed the massive over inflation of tech stocks, the sub prime crisis was part of a massive inflation in the prices of junk bonds and the derivatives that are built around them. These credit default swaps were packaged into bonds which securitised the cash flows from highly risky mortgages – and instead of offering these bonds at very high yields/low prices, investor demand pushed up prices and lowered yields to levels which clearly did not compensate investors for their risk. Why did investors buy these bonds in the first place? Very simply, they did so because they believed (like every other bubble market participant since the South Sea Bubble in the 17th century) that prices would keep on rising. Unfortunately when you pay above fair value for an asset you will eventually be punished for doing so!

It is worth unpacking some of the more frenzied media commentary to understand the accuracy of predictions of looming economic failure. In an article which appeared in the Fairfax press on 19 July 2008 under the headline "Crumbling Foundations Shake the US" Anne Davies didn't bother to disguise her anti-market/capitalism beliefs: "Has deregulation failed the American public? Why are US taxpayers being asked to bail out the top end of town when thousands of people are losing their houses every day? And the big question: where the hell is the US economy headed"? (Sydney Morning Herald, p 44, 19 July 2008)

We can quickly dispense with each of these points. Deregulation did lead to the freedom for banks to create sub prime mortgages; the market has worked efficiently to punish those same banks and investors. US taxpayers are not bailing out the "big end of town", in fact they are supporting the key economic institutions upon which US citizens rely for home and business loans, credit cards, bank accounts, jobs and finance. US taxpayers are bailing out – themselves. There is no free lunch for senior bank executives in this approach from the US Fed Reserve and Treasury – employees of Bear Sterns took much of their pay in the form of shares, and the rescue package for Bear Sterns allowed JP Morgan to buy Bear Sterns shares at US$2 per share (revised up later to US$10 per share). For executives who were granted shares at prices as high as US$130 per share, this can only be described as a personal financial catastrophe – hardly a "bail out" of the top end of town.

It's often stated now that the worse is yet to come from the subprime crisis, as the low interest holidays in the early years of sub prime mortgages are due to rise when the first interest rate reset date arrives. For the 1.5 million loans that reset this year (many have already done so ie this impact is already priced into the market) the reality is that the typical 3% to 4% rate rise after reset has largely been offset by the US prime rate reductions which have dropped US rates to 2%. For most sub-prime investors the real cost of their new rates will be very similar to the initial honeymoon period.

But that doesn't mean that borrowers won't default. Certainly the US economy is suffering from slow growth which feeds on itself as jobs are lost and spending declines. The US economy will recover but the time it will take to do so is unclear. But what about the rest of the world?

China will continue to lead global economic growth. US and Europe account for no more than 2% of China's GDP growth. Figure 1 shows that emerging markets including China continue to grow even when the US economy slows down; and during the last 2 periods of US slowing in 2002 and 2004, these emerging markets continued to grow. This is happening again in the 2008/09 period.

Figure 2 confirms that the current commodity cycle is linked more to the growth of China than to US growth, with China accounting for more than 50% of the demand for many key commodities such as steel, iron ore, copper, coal and meat. Insert graph from page 39 Credit Agricole

China and its Asian trading partners will continue to grow because they are coming off such a low base, with rising domestic affluence underpinning strong internal demand for goods and services. This growth will underpin rising commodity prices which flow benefits back to their producers such as Australia. Figure 3 shows the effect of rising household incomes in China, noting that a household income below US$3000 per annum can be considered as a subsistence income (expenditure on food and clothing are a very large share of incomes below this level); whilst household incomes above US$3000 allow for savings and consumption (eg cars, phones, white goods). By 2015 more than half of the urban Chinese population will have household incomes above US$3000. This strong internal demand shows that concerns of a US led slowdown in China's economy are over-emphasised.

The RBA has aggressively increased Australian interest rates to slow down rising inflation. RBA Governor Glenn Stevens has led a harsh attack on inflation and its important to understand what the RBA attitude is to this inflation, in order to gauge how long rates will stay high. In the most recent indication given by Stevens in a speech to the American Chamber of Commerce in Australia on 13 June 2008 (Click Here)

Stevens noted that Australia's economic growth is linked to China now more than to any other country in the world. Noting that the IMF now predicts that global growth will moderate this year to 3.75%, Stevens points out that this is growth is in line with long term averages:

"But while this outcome for global growth would be well below the exceptional pace of about 5 per cent seen in 2006 and 2007, it is actually in line with the average rate of growth for the world economy over the past 15 years. And although the IMF suggested in April that the short-term risks surrounding this forecast were concentrated on the downside, with a 25 per cent chance of global recession (which it defines to be global growth at or below 3 per cent), recent developments do not suggest that those risks are any more likely to be realised than was the case a couple of months ago... The effect of China on the rest of Asia, moreover, is expansionary. Coupled with fairly easy monetary policy settings in much of the region, which tends to occur in many emerging economies when US policy rates are very low because of the importance of exchange rate considerations to Asian policy-makers, this is likely to limit downside risks to growth in the short term." (Emphasis added).

This part of Stevens speech is consistent with the weight of data confirming the ongoing demand for Australian commodities. Australia will continue to grow even as the US and Europe slows. But what about the problem of inflation? Stevens indicated in this speech that the RBA is now seeing evidence of the containment of inflation, and this has led to widespread predictions that the next Australian rate move will be down:

"Combined, these developments are having a dampening effect on demand. Households have, over recent months, adopted a more cautious attitude to borrowing and spending, the evidence for which is a string of flat results for retail sales, and a significant decline in the flow of new loan approvals for housing. Credit approvals to businesses have also declined significantly...total business funding has slowed. In short, things are happening that suggest a moderation in growth in domestic demand is occurring, signs of which were beginning to appear in the national accounts data released last week. At this stage, inevitably, the extent and likely duration of the moderation remains uncertain." (Emphasis added)

Rational fundamental analysis of the current levels of the Australian share market shows that quality blue chip stocks are trading below fair value. We look in more detail at the stocks in the Alpha POWER Shares portfolios in our stock picker's reports below. In general we agree with the sentiments of asset consultant's like Frank Russell:

"SYDNEY, 16 July 2008 – Amid the current market turmoil, investors with longer time horizons should recognise the value currently on offer. Investors are being offered the opportunity to buy future growth and profits at significantly discounted prices according to the latest quarterly Russell Investments Market Barometer. The report found that while more volatility seems likely in the near future, investors with long-term investment horizons can now maximise returns and take advantage of discounted prices. Despite the local market facing market volatility in the near future, the long-term valuation characteristics are sound. The one-year forward PE ratio, at 12 times for local equities is lower than when the bull market kicked off at the end of 2002." (Frank Russell, Click Here)

Expect a positive re-rating of the Australian share market over the next few months as corporate earnings are announced, and as inflation/interest rate concerns abate.

We can see from this analysis that fears of a global economic meltdown are significantly exaggerated. Key economic indicators confirm the resilience of the global and Australian economies. So what is driving stockmarkets so aggressively down? As long term Alpha clients will be aware, it is well known that when markets start to fall, traditional fund managers are forced by their investment mandates to react by selling stocks. This compounds the effects of the market falls. In Australia high interest rates have contributed to many of these fund managers staying out of the stock market and in cash, thus reducing demand and allowing prices to remain low. These investors will return to the market as its positive re-rating occurs in coming months.

It's also well known that hedge funds have drastically increased the level of short selling in the recent past. Short selling involves borrowing shares (which have to be returned when the stock loan is unwound), selling them at current prices but in such high volumes that share prices are pushed down, and then buying those shares back at lower prices for return to the original stock lender. Short selling is prevalent when bad economic news is released, and is successful because ordinary investors can't tell whether sliding share prices are real, or result from artificial market manipulation. US regulators have recently tightened rules against this type of manipulation, whereas Australian regulators have been far slower to react. It is clear that short selling is one of the largest contributors to the severe stockmarket falls over the last 12 months:

"More than $US1.4 trillion of equities worldwide are now on loan, about a third higher than at the start of 2007, data compiled by Spitalfields Advisors, the London-based firm specializing in securities lending, show. Almost all of that is being used to speculate that shares will fall, according to James Angel, a finance professor at Georgetown University who studies short selling." (Sydney Morning Herald, July 21 2008, Click Here)

Our prediction that market weakness will lead to a wave of new "hybrid" security issues has been fulfilled, with the recent announcement by Westpac of a new type of hybrid which pays a very attractive coupon of 2.4% above the prevailing bank bill rate. These new hybrids are effectively "cash back" securities designed to return the original investment price to investors in 2013. At this level of return, the new Westpac hybrid is a cracker and offers a very attractive yield for very low risk.

The new Westpac hybrid is designed as a "Stapled Preferred Security" which combines an investment in a converting preference share issued by Westpac, along with a perpetual subordinated note issued by the Westpac New York Branch. The main component of the instrument is the Australian issued converting share, since this is the vehicle for the payment of the dividend and ultimately for the return of the investor's capital. All Westpac ordinary shareholders will be offered an allocation of SPS based on whether they were on the Westpac share register as at 11 June 2008.

Based on the performance of hybrids like the Westpac SPS prior to the credit crunch and stock market downturn last year, at this level of dividend it is likely that the SPS will trade at a premium to their issue price upon listing. So even if a Westpac shareholder doesn't wish to be a long term holder of the SPS, taking up their entitlement and selling down upon listing should generate a "stag" profit of potentially 5% to 10%. While the payment of the dividend is subject to the usual requirement that Westpac must have an accounting profit or sufficient retained earnings to pay the dividend, banks typically do have the capacity to pay hybrid dividends – and if they can't, then they are prevented from paying dividends on their ordinary shares until the unpaid hybrid dividend is met. This "dividend stopper" is a powerful practical indicator that preference dividends will be paid.

It's unfortunate that the vagaries of our tax, accounting and prudential rules require the creation of the somewhat complex stapled structure in the Westpac SPS. Expect that Westpac, as a major global bank, will allow the mandatory converting preference share to operate in accordance with its terms. This means that it will pay the preference dividend at the margin set by the bookbuild until 2013, at which time it will convert into ordinary shares or be redeemed at par by Westpac. There is a provision which allows Westpac to trigger a transfer of the SPS at par to a third party instead of simply redeeming them itself. If conversion occurs, this will cause the issue of enough Westpac ordinary shares to investors (at a 1% discount to the prevailing share price) to give the SPS holder value equal to the original issue price of the SPS.

Westpac can avoid conversion, if the ordinary share price during the conversion period falls, such that conversion will be overly dilutive of the existing number of ordinary shares. This means that if the Westpac ordinary share price is low in 2013 the bank may instead be able to redeem the SPS for cash, or trigger a sale at par to another entity. This slight risk to SPS holders shouldn't in practice dampen their enthusiasm for this attractive new hybrid issue.

Dr Tony Rumble

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