At the close of trade last Thursday, most commentators were assuming that a correction was under way. By Friday afternoon giving the benefit of doubt to an established trend again seemed the safer strategy.
Even so, Thursday’s 2.3% decline, on high volume could be an early warning of the potential for more volatility as this rally moves to higher (and riskier) valuation levels.
In this outlook, I review the daily index chart and make a few observations on some of the week’s major risk events.
Valuation Theme – Scope for volatility
An adjustment to valuations not an improved earnings outlook remains the driving force behind this rally. Investors are prepared to pay more for stocks given perceptions of reduced global risks and the incentive created by low yields on fixed interest investments.
The forward price earnings ratio on the 200 index continues to rise. The index PE based on a survey of next year earnings estimates by Bloomberg hit 15.3 at the close last week. .
The sector analysis tool on our stock broking platfrom provides similar analysis and also gives a good overview of Price Earnings valuations and dividend yields for the different industry sectors. At this time of the year the 2 year rolling figure in this table is pretty close to the Bloomberg next financial year out (14.9 v 15.3).
Interestingly, the 200 index makes up 93% of the value of all the stocks listed on ASX while the 300 index accounts for 95%. So there’s not much difference between them.
If you trade CFDs with CMC but not stocks , I encourage you to have a look at our stockbroking platform. Brokerage rates start at $9.90 and the platform has been judged by Canstar to offer Australia’s best value.
In past weeks I have shown charts indicating that at current levels, index PE’s are at about mid range for the years leading up to 2007.
This gives plenty of scope for a move in either direction.
- A sharp sell off if the market gets a fright
- But potential for another 10% to the upside given current low interest rates.
Last Thursday’s price action is a reminder that with PE values now into mid range, the correction has the potential to be sharp and steep when we eventually do get a breach of major support levels.
The trend channel support line continues to hold. Thursday’s low stopped at that level.
Even though we’ve had quite a bounce, the last 2 candles are still inside Thursday’s range. A move past Friday’s high would be more conclusive evidence that Thursday’s big fall was not the start of something larger.
A move below 20 day moving average (middle Bollinger Band) and the early February peak 4943 on the other hand would be needed to provide evidence that a correction of the whole rally since November might be under way.
Approaches to trading this broad outlook might include:
- Short term traders continue to trade the channel. Buying at the support line with stops just below and taking profits at the resistance line
- Medium term traders riding the uptrend might now have stops trailed up behind the 20 day moving average
The Week Ahead
There are quite a few risk events for the market to negotiate this week. There’s not room here to comment on them all. Here are some brief thoughts on the possible trading consequences of some.
- Mr Bernanke’s testimony before Congress
One of the things I intend to regularly remind myself of over the next couple of years is that the early stages of Central Bank tightening cycles are usually bullish for markets while the financial markets commentary about tightening is usually bearish.
Central banks withdraw monetary stimulus as economic growth improves. In the early stages rates rising from low levels are not enough to stop consumers spending or investors investing. Happy times for stock markets.
The current circumstances may be a little different. Last week’s Fed minutes showed governors discussing a possible tapering off of quantitative easing because the risks of using it may be rising while its effectiveness is declining and not because they saw the economy growing strongly
Even so, it seems unlikely that the Fed would do anything to really tighten policy to the extent that it pushed money out of shares and into cash unless growth is considerably stronger than it now is and/or share valuations are considerably higher than they now are.
If Mr Bernake’s testimony does add to speculation that the Fed will wind QE down a bit earlier than expected, it seems to me that any sell off this causes is likely to be a correction and a buying opportunity rather than a game changer.
- Australian Private Capital Expenditure
This is due for release on Thursday and is an estimate of capital expenditure by the private sector in the December quarter. It includes spending on buildings, infrastructure, equipment, plant and machinery.
One of the dominant themes of the Australian market in recent months has been an expectation that the investment in mining infrastructure has peaked and will need to be replaced by growth in other areas to prevent economic slowdown. The market is expecting capital expenditure growth of only 1% for the quarter. This represents a weakening trend in the context of a 14.2% increase over the 12 months to September.
There could be a bit of an RBA put option here. Reaction to a very weak figure may be tempered by a decline in the Aussie Dollar and the increased likelihood of further rate cuts.
- US Budget
If the sequestration changes to the US budget aren’t modified there will be a substantial additional drag on US growth over time.
Markets appear to be taking the view that politicians will ultimately act to compromise on this. This is probably right but stop losses on long positions are a must. If the politicians disapoint, the economic and market consequences could be significant.