A good read on market direction

Look at the p/e's on the US stocks ??,
a bit more to go yet



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Third Quarter Activities Report

PLATINUM CAPITAL LIMITED 2002-04-09 ASX-SIGNAL-G

HOMEX - Sydney

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COMMENTARY

The power of low cost money, with the Fed fund's rate at a 40 year
low of 1.75%, has worked much more effectively than we had dared to
hope. Not only have we seen a strong rebound in consumer spending in
the US, but business confidence in Europe has also rebounded; for
four months in a row now the IFO survey of expectations in Germany
has been rising. This has been anticipated by the market so, as noted
earlier, there has been a surge in the value of cyclical stocks.

The focus has now switched to the prospect of tightening interest
rates (Sweden and New Zealand have already raised rates). A measure
of this is revealed in the forward rates which imply rises of 100
basis points late in the northern summer. As we remain somewhat
ambivalent about the strength of the recovery we suspect these
forward rates may exaggerate the actual outcome, although, there have
been some surprisingly large price rises in several commodities which
are prima facie in abundant supply eg steel, various plastics, etc.
Nearly all the companies we visited in March expressed disappointment
with order levels, with only one out of the 40 companies seeing any
indication of improvement. De-stocking has been taking place at an
abnormal rate (see the attached figure of US inventories).

The piece we wrote last quarter on Enron proved prescient so we do
not share the general feeling of surprise and betrayal. We have long
bored our readers with complaints of wholesale transference of
corporate ownership via vast stock options - which in addition fail
to be accounted for correctly. We have complained about accounting
practices, dubious recognition of revenues and worse still, the role
played by investor relations officers to apply spin at every turn.
Another matter that gets less than due coverage is the predilection
of investment bankers to value shares on operating earnings - so
called EBITDA (Earnings Before Interest, Tax, Depreciation &
Amortisation). This may suit those pursuing M&A fees but does little
to inform real investors. The "D&A" part masks all manner of
accounting iniquities and the "I" part confuses the fact that
shareholders are the last in line to get free cashflow, the source of
dividends, retained earnings and the ultimate reason for INVESTING.

The above comments may not seem important to some but illustrate a
system that is facing serious imbalances. The Enron debacle and
revelations of dubious associated dealings highlighted the amount of
off balance sheet risk that prevails. This risk becomes more real as
interest rates turn and positions have to be covered.

It has been the ability of the Government's sponsored enterprises
such as Freddy Mac and Fanny Mae to cope with massive housing
mortgage refinancing that allowed the US consumer to fund housing at
progressively lower rates throughout the economic slowdown and
simultaneously to free up funds for the purchase of other goods.
These entities have progressively increased their exposure to
interest rate risk and credit risk. They are, in fact, monumental
hedge funds with equity gearing of 64 times through their
guaranteeing of mortgages against default and their ownership of
portfolios of mortgages. A high proportion of their borrowings are
funded short term which at present low rates allows them to make good
spreads. To mitigate the risk of a rise in rates they are obliged to
be aggressive users of options instruments. As matters stand today a
rise in rates need not necessarily cause them great loss but there is
no telling whether there will be a period of volatile interest rates
nor is one able to predict the behaviour of borrowers. It is
difficult to calculate the option premiums they are paying annually
but between the two of them it could be as high as $4 billion.
Receiving those fees are investment banks and other institutions. In
unstable times these interest rate "insurance policies" could become
credit risks as margin calls mounted.

The important thing for investors to recognise at this point is that
the tide may have now turned. Regulation of corporations will become
more stringent, money will tighten and input prices may be on the
rise. This is the very opposite of the experience of recent years and
implies downward pressure on the reported profits of some companies.

As we look at world markets we continue to be attracted to the values
we find in Europe. While this economic block may be slower to come
out of the trough than the US we are reasonably comfortable the
shares we own are realistically valued. Below is Morgan Stanley's
price earnings ratio projections for the US, Europe and Japan.

PROSPECTIVE PRICE EARNINGS RATIOS


Region
2002 2003 2004
Europe MSCI 18.8 15.8 14.9
US 30.6 24.8 23.4
Japan 24.1 18.7 17.9

We are reluctant to follow the crowd and tilt the portfolio
decisively in favour of cyclicals because of the reservations voiced
above. We have been adding to companies that are in defensive
industries because they are attractively priced but somewhat
neglected as investors chase after cyclicals; this is another way to
say that the market is already building into cyclicals a fair degree
of recovery.

The other fashionable area at present is emerging markets. We see
Korea as our representative in this arena though we also have some
money in China and India. Some of our Korean shares have been
exceedingly strong and as noted above we have tended to sell into
that strength. For completeness it should be said that we remain
comfortable with our positions in Japan with the caveat that we
continue avoiding the Japanese Yen.

CONCLUSION

Many markets have already built in valuations which partly reflect
the anticipated recovery in economic activity globally. Valuations
are reasonable in some areas but in a broad sense are not compelling,
particularly as we believe there will gradually be leakage of funds
out of overvalued sectors such as retailing in the US and some big
capitalisation names. These remain our area of attention for
shorting. At this stage we believe that high valuations and
uncertainties such as rising oil prices and the traumas in the Middle
East will restrict the scope for a broad and aggressive advance in
share prices globally.


K Neilson
MANAGING DIRECTOR

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