… The magnitude of the rally has put Rolls Royce on a forward PE of over 18x earnings, the most expensive in its peer group and almost 70% higher than the sector average.
A glance at the chart below of the FTSE 100 shows how the blue chip index has paused for breath this week, as investors digest the recent central bank updates.
After a two day meeting the US central bank left interest rates on hold and pledged to keep them at record lows for an “extended period”. The Federal Reserve (FED) also stated that it would slow the pace of its purchase of mortgage backed securities to a later date than originally scheduled.
The Bank of England (BoE) was also in focus after the release of the minutes from the September meeting, which showed it voted unanimously to keep the asset purchase program at £175 billion. However, governor Mervyn King suggested that the door has been left open for further quantitative easing going forwards.
Both central banks noted the recent stabilisation and improvement in economic and financial data, although they remained cautious. Continued rising unemployment and sluggish income growth are likely to weigh on the economy and cause a protracted return to “normal” growth levels.
Interestingly the Vix index of equity volatility, a closely watched measure of risk aversion, has not improved since mid-July even though the FTSE was trading around 14% lower than it is currently. This lack of conviction is echoed by the extremely low volumes apparent in the market over recent months.
Technical analysis highlights the continuation of the sharp bullish channel formation that has been in place since early July, with the upper boundary now seen at 5470. The relative strength index (RSI) is marginally below its recent highs, but not enough to suggest that the rally is loosing momentum at this stage. However, a close below 5050 would be significant as it would suggest a break of trend and could initiate a more substantial move lower.
The FTSE looks set to post its strongest quarterly percentage gain in its history, with a rise of over 20% currently seen since the end of June. The speed and aggression of the buying indicates more of a heard mentality, which is often hard to predict and tends to focus on the technical outlook.
In summary, the inherent momentum and strong technical trading channel should not be ignored. However, the speed of the rally coupled with the low volumes makes me nervous and cautious to buy the market at these elevated levels.
Much focus will be on the G20 (Group of twenty finance ministers and central bank governors) meeting in Pittsburg this weekend and I believe that any suggestion of quantitative tightening could trigger a sharp contraction in equities.
Equity markets do not rise in a straight line and even in bull markets, pull-backs are inevitable and healthy. Timing these dips is difficult, but by focusing on stocks that have doubled from their lows and now trade on a forward PE ratio of greater than 15x it can help select stocks that may be vulnerable to some consolidation.
As a result, the focus of this week’s article leads me to re-visit Rolls Royce (Epic: RR.), which is an aero-engine maker for both military and civil aircraft and is a big supplier of power generating turbines to the marine and energy markets.
As can be seen from the above chart of RR the shares have doubled since the lows experienced toward the end of last year.
The magnitude of the rally has put them on a forward PE of over 18x earnings, the most expensive in its peer group and almost 70% higher than the sector average. It also puts them at a premium of over double the likes of BAE Systems, which is another FTSE 100 defence company.
Analysts are already forecasting the group’s growth to fall next year and recent news surrounding government cost cutting is likely to further impact this. Gordon Brown has already said he is willing to cut Britain’s fleet of trident missile carrying submarines from four to three as part of global disarmament efforts and this will negatively affect RR’s naval business. Furthermore, the continued assault on its staple aircraft business, with 25% of fleets still grounded will be costly to the company.
Directors and funds have also started to let stock go. John Cheffins, chief operating officer sold 300,000 shares (circa £1.5 million), which represents almost half of his holding this week and Collin Smith the director of engineering lightened his position. Funds such as Legal and General have also been reducing their holding.
Technical analysis suggests the shares may have rolled over, with the RSI and stochastic posting fresh short term lows indicating that the momentum behind the recent gains is declining.
Sharp re-ratings are not unusual as earnings approach trough levels and investors try to price in recovery. However, in light of the above information and excessive premium to the sector the current re-rating is alarming and increases their vulnerability to a correction.
At the time of writing the share price is 474.2p and my short term opinion is that the shares will continue to move lower. Near term targets are seen at 448.5p, 433p and 422 and with a stop loss marginally above the recent high at 503.5p, I believe it offers an attractive risk/reward basis.
This report was written by Mark Allen – Head of derivatives at Simple Investments Stockbrokers. The writer does not hold a position in Rolls Royce. The material in this report has come from Simply Charts and Rolls Royce’s corporate website.