Even as the benchmark TA-25 index trades at record highs and many analysts claim there is little in the way of further gains, Merrill Lynch's Haim Israel said on Thursday Israeli stocks are in for a "bumpy ride" in the second quarter as the local market becomes more sensitive to global trends.
"MSCI Israel is seeing a shift away from its traditional role as an emerging market portfolio diversifier and succumbing to GEM (global emerging market) volatility," Israel wrote in a note to clients.
As a result, he said, the index's beta, or relative volatility to the GEM is well-above its one-year average, having doubled to 0.65 from 0.28 in January 2006.
"While we do not see this as a reason to unreservedly advocate buying Israel when risk appetite increases, we do expect Israel to be more responsive to GEM trends," he said.
That change in beta, he said, should be taken into consideration by investors when making short-term investment decisions, as he believes the Winograd probe provides political noise from a micro perspective and the GEM volatility noise from a macro perspective.
"We generally tend to ignore political noise as its effect on the market tends to average out over time, but in this case the outcome of the Winograd Committee investigation into the Lebanese war is likely to bring Israel's elections a step closer," Israel wrote.
Nevertheless, he said, the committee's recommendations, which could result in the resignation of Prime Minister Ehud Olmert, should not affect the course of trading. Although the markets don't like political noise or elections, he believes leadership changes in the Kadima and Labor parties could stabilize domestic politics for the time being.
"We think an early election is still probable and we may see four to five months being lost in a fruitless pre-election environment," he said, adding that polls were leaving out an element of surprise as they indicate a clear lead for Likud.
"A coalition government under [Likud chairman Binyamin] Netanyahu may take a more hardline stance on foreign policy, but the markets are likely to welcome it as the current strength of the Israeli economy owes much to the politically unpopular structural reforms and fiscal discipline adopted during his previous days in office," Israel said.
While he is not changing his general view of paying little attention to local political events, the analyst said he would take the opportunity to buy high-beta names if the report did translate into market weakness.
If stocks fall on political uncertainty, he recommends names like Ormat, ICL Israel Chemicals Ltd. and Makhteshim Agan. Should higher volatility emerge in global emerging markets, he suggests purchasing Teva Pharmaceutical Industries, Strauss and Elbit Systems, while for benefits from tax reforms he says investors should look at Supersol and Strauss.
Despite the short-term concerns, Israel told clients he believes the local market will generate positive returns this year, but to a lesser extent than in 2006, on lower GEM returns, stable emerging market liquidity and strong macroeconomic fundamentals, which he said were all already partly factored into share prices.
"We domestic liquidity remaining the name of the game in 2007 and expect the beneficiaries of private consumption trends and those stocks that are sensitive to looser monetary policy to outperform. the market," he said.
Therefore, for the long-term, Israel advocates a "stock picking" strategy that focuses on cash generation rather than on purely domestic names.
"We continue to prefer Bezeq, Ormat, ICL and Makhteshim Agan, but are removing the banks from our long-term recommended list," he said.