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Page last updated Monday, 16 November 2009
Equities Bulletin - Issue 51 : November 2009
The sharemarket – running out of puff?
By Zac Zacharia
It’s amazing what a change a few months can bring to the stock market – and investor sentiment! Following on from my previous article featured in the June 2009 edition of Equities Bulletin, I mentioned that the market was at a crossroads and we were expecting a pullback first followed by a rally that would confirm that a new bull market had in fact commenced. This pullback occurred in early June 2009 – with a 4 week decline of approximately 9% that ended in early July 2009 at 3710.1. Since then, the market started an accelerated uptrend that seems to have found resistance at time of writing at 4897.5 in mid-October – just shy of the psychologically significant 5000 level (which coincidentally is also 50% of the downtrend – a significant resistance level in any market). What happens next will define whether the last 8 months were, in fact, the start of the next long term bull market – or just a substantial bear market rally.
Fundamental Signals
The 58.7% rally since March 2009 was driven primarily by investors regaining optimism on the back of signals that the worst of the global financial crisis was behind us. Everyone can agree that Australia has fared well through it all, avoiding a technical recession when other developed economies succumbed. As credit markets started to thaw, the most recent reporting season provided nervous investors with confidence that company defaults were to be lower than expected, and that balance sheets were substantially stronger (due in part from the myriad of equity raisings over the past year).
The public has revelled in the generous government stimulus packages provided to keep the economy moving and economic data confirmed this sentiment - suggesting that industrial production was increasing again, business and consumer confidence was growing, and that there is an end in sight to rising unemployment. Emerging markets, in particular, were also becoming stronger - and all eyes turned to Asia again to fuel Australia’s GDP growth. Demand indicators should start to spread across sectors and countries, and even housing activity is starting to pick up again in the UK and USA, albeit from historically depressed levels.
This acceleration phase is very likely coming to an end, however, with economic growth expected to remain strong, but not accelerate at the same pace. Moving forward one should not expect the same level of positive surprises from the economic data. Now that the risk of serious economic weakness has abated, the RBA is likely to wind down its insurance policy (by raising the cash rate) and target 4% within the next 6 months – in a delicate balancing act to maintain inflation at manageable levels. The economic recovery (or slowdown in deterioration) has taken even the RBA by surprise, and Australia’s GDP is now forecast to grow by 1% in 2009 to 2.9% in 2010.
As for valuation support for stocks, the profit outlook has become more robust following the August reporting season. Consensus earnings estimates point to a slightly weaker 2010 financial year in terms of earnings per share, an improvement from the position a few months ago. Meanwhile, estimates have consolidated for 20% earnings per share growth in 2011. A price/earnings ratio of 16.1 times earnings for the next 12 months sits above the long-term average of around 15.5 times.
However, a broad-based turnaround in 2011 earnings brings the valuation multiple back to a more acceptable level and astute investors should consider accumulating portfolio positions across a range of sectors and stocks, including AGL Energy, Origin Energy, CSL, OneSteel, CSR, Orica, United Group, IAG, QBE, Telstra, ANZ and Westpac.
Chart Signals
The Weekly Charts confirm what investors are feeling and economists are saying. When an investor analyses price charts, there are certain things to look for to provide confirmation:
- Trend Direction
- Trend Momentum
- Sentiment of participants
- Commitment to the trend
Trend Direction
Figure 1
Figure 1 above (representing a weekly close line chart (black line) of the All Ordinaries Index overlaid with a 30 week moving average as a blue line) shows the stellar rise since March, and also illustrates clearly the June 2009 pullback that we were awaiting. This chart also confirms that our market is clearly trending up over a 12 month period: note the higher peaks and higher troughs, and also the fact that the Index is above its 30-Week moving average. It is however very far away from this average, suggesting that the Index was overheated - and at time of writing experiencing a pullback. Remember that corrections in a bull market are buying opportunities.
The chart also shows the upward channel within which the Index has been trading, and how the Index has been finding significant resistance against the upper channel line – further confirming that a pullback was likely. When price action hits a resistance zone, an investor may consider taking profits - or lightening positions, particularly those that have participated in the significant rally. The pullback is likely to find support at approximately the lower channel line, in this case, around 4450-4500. A break of this level, and also of the 30-Week moving average is bearish.
Trend Momentum
Figure 2
Figure 2 below includes an indicator called the relative strength indicator (RSI) - which is a useful momentum indicator. Long term, it is clear that momentum is trending up, however in the short term, it is apparent that the upward momentum had lost strength (the RSI indicator has fallen from extreme highs and pointing down).
Note also that there is a potential level of support coming up for this downward momentum to slow down and turn back up at the uptrend line shown on the RSI indicator below.
Sentiment
Figure 3 below shows the All Ordinaries Index overlaid with the “Guppy Multiple Moving Average” template, which is a series of long term and short term moving averages coloured red and blue respectively to represent long term and short term investor sentiment.
Short term investor sentiment (blue lines) has been bullish since July 2009 when this group crossed above the longer term sentiment (red lines). Sentiment of the latter group has started to turn up and become bullish and provided the shorter term sentiment doesn’t decline below the red group, the market is likely to establish a sustained longer term uptrend.
At the time of writing, short term sentiment is starting to turn slightly negative, a common occurrence when there is profit-taking amongst shorter term investors.
As an investor, we do not want to see the blue group dip under the red group as this will be a bearish signal - indicating that the bear market has resumed and both groups of investors are negative.
Figure 3
Commitment
Figure 4 shows an overlay of the on balance volume (OBV) indicator (blue line) which represents whether volume is flowing into or out of the market. Positive volume flow (represented by the OBV rising) is a sign of commitment to the trend as money comes into the market.
I have also added a 30-Week Moving Average of the OBV (shown as a red line), and one can clearly see how money started flowing back into the market from late March 2009 when the OBV crossed above its moving average and rose. This provided the fuel for the trend which we have seen over the last 8 months. An interesting observation is how in recent weeks the OBV has reached an extremely high level which is approximately the highest level that the bull market reached in November 2007.
Figure 4
Where to next?
Based on the above analysis, I present two possible scenarios that could unfold over the coming few weeks to months:
Scenario 1:
An investor should expect a pullback in any healthy bull market, especially so when the market gets ahead of itself and rallies strongly for more than 4 weeks in a row. Typically, these retracements can be up to a 10% decline in prices, or they can cause the price to move sideways for a period of time. In either of these situations, the pullback should occur on lower volume than that which was seen when the price was trending higher.
The most likely technical scenario for the All Ordinaries Index in the near term is that it will continue to retrace towards the lower channel line of the uptrend (which started in March 2009) - at approximately the 4450-4500 zone (61.8% of the rally since July 2009 and 78.6% of the rally since March 2009) – and hold, prior to resumption of the uptrend.
Should this level be broken however, further support levels are likely to be around 4300 (50% of the uptrend since July 2009), 4200 (61.8% of the uptrend that started in March 2009) and finally 3900 (50% of the uptrend that started in March 2009).
Either one of these support levels is likely to provide sufficient momentum for a bounce that could attempt to retest the previous high. It is important to be aware that the deeper the pullback is, the harder it will be for the index to rally and retest – let alone break - the previous peak of 4897.5.
One thing that is very likely though is that the subsequent rally (once the market finds support at any of these levels) is going to be slow and somewhat restrained. Investors will await further positive economic data and validation from things such as companies’ earnings in the first quarter reporting season to determine whether share prices are indeed matching valuations.
Scenario 2:
Although unlikely, the All Ordinaries Index could experience a deeper pullback over the next few weeks and months and break 3900. It is difficult to predict what catalyst would cause such a catastrophic decline, but should this occur, it will likely confirm a possible recommencement of the bear market, and categorise the rally since March 2009 as just a massive bear rally!
Therefore, the 3900 level is an important one if it is ever broken and could well drive the market down to the March 2009 lows again. Therefore, it is the absolute level where the conscientious investor should reassess their entire portfolio.
Final Thoughts
As I mentioned in a previous edition of the Equities Bulletin, astute investors should regularly review their portfolios - at least weekly - to assess when it is time to “hold em”, and when its time to “fold em”. I do this weekly for all my clients’ accounts using the methodology I described above. Remember, you will never consistently pick the exact top or the exact bottom - but at least you will be on the right side of the market as its moving up, and out of the market when it gets turbulent.
The most difficult thing investors encounter is the emotional battle of selling a stock – especially if it was purchased at a significantly lower price. But as we have discussed in prior articles, there’s a time to be invested in the market and a time to be invested in cash.
A useful tool to assist with this decision is to analyse price charts systematically and objectively to determine whether investor sentiment and the price trend is changing for a particular investment.
Being proactive is certainly the key to successful investing.