Last Monday, a double top formation looked possible. As the week unfolded, this possibility was negated when the index moved past recent highs.
Even so, the move to new highs has been a pretty “limp” affair so far. At this stage the index has failed to move convincingly past the peak established on 20 February.
In this week’s outlook I discuss, the implications of this price action for the technical outlook and outline some thoughts on why the current rally is becoming riskier from a valuation point of view.
4 Hour Chart
Last week’s low momentum move to recent highs is starting to look as though it could develop into a wedge style pattern. I’ve started with the short term 4 hour chart to outline this more clearly.
The daily chart shows the recent sideways movement in the context of the longer term trend.
The rally since November has been mainly about improved confidence and expanded valuations. If this driver continues, a break through resistance levels can itself attract new buyers. Investors sitting on the sidelines waiting for a correction give up on the possibility of getting in at lower prices and buy as prices break to new highs.
A clear break through the red wedge resistance would indicate continuation of the uptrend and another move towards the larger blue trend channel resistance.
Looking at the downside possibilities, the short term support between 5100 and 5060 looks to be growing in importance. In this range we now have the blue trend channel support; the 20 day moving average and the red wedge support.
As I’ve noted in past weeks, it’s usually best to respect a powerful uptrend like this one, waiting for a clear break before assuming it has ended. However, a strong move through and a close below the 5060 support could well indicate the beginning of the much predicted downward correction.
The support levels I mentioned are rising trend lines and moving averages. This means the support zone will rise over time and not stay fixed in this 5100/5060 area.
Valuation Theme – yield stocks and resource companies go separate ways
Comparing the 2 biggest stocks in the index, Commonwealth Bank and BHP provides a good snapshot of why the market has struggled to move far in either direction since 20 February.
Since that time the chase for yield has continued with investors buying banks and more recently retailers. At the same time, resource stocks have declined as the market anticipates a decline in iron ore and oil prices and perhaps a softer growth rate in China
Hint: You can easily make these quick visual comparisons using Tracker charts. Just open a chart and then drag the symbol for another cfd onto it either from the product library or one of your watch lists. This can be a very useful way to get an insight into what’s driving markets and to identify pairs trading opportunities.
Valuation theme – from here on up, things get riskier
In past weeks, I’ve shown charts that make it pretty clear that this rally has been about expanding PE values rather than about investors expecting stronger company profits.
When markets are driven by a dominant theme like this, I find it can pay to think through how the theme may play out in future. As usual, it’s best to stay flexible and not be wedded to any particular forecast. Even so’ the process of considering in advance how the dominant theme might play out, can help improve your reaction to future news events.
So I thought I’d finish off this week with some thoughts on what the withdrawal of central bank stimulus could mean for the index.
In recent weeks, I’ve made a few points
- The Index price: earnings ratio is currently not far above long term average levels
- However, earnings yields are by no means expensive compared to fixed interest yields. If returns on fixed interest investments stay low there is plenty of scope for the stock market valuation rally to continue without making it expensive compared to bond yields.
- I plan to remind myself that the beginning of central bank tightening cycles has normally been bullish for markets although there is often some short term selling when rate increases are first announced.
This time around the market reaction might depend how much further this valuation rally goes before the Fed begins to tighten. There could be a couple of different scenarios
- Bullish scenario – Fed and RBA start to tighten at a time when the stock market is close to long term average PE values. In this scenario, bond yields could rise towards their average long term levels without shares having to sell off from their long term average values. Not only that, central bank tightening would suggest improving economies and the likelihood that company profits will grow driving higher share markets
- Bearish scenario – Share index rallies a lot further before Fed and RBA start to tighten. In other words both bond and share yields would be well below their long term average. In this scenario, PE valuations would be depend on very low interest rates continuing. If those rates become likely to move higher, the stock market could drop back towards its long term averages i.e lose any future value and move back to around current prices or a bit below.
The bottom line of this line of thinking is there remains plenty of scope for the index rally to continue. However, from here on, this rally will be riskier. It will depend on the outlook for low interest rates continuing.