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Michael McCarthy
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+ About Michael McCarthy
Michael McCarthy is chief market strategist for CMC Markets in Australia. He has over 30 years of experience in financial markets – specialising in equity trading and trader education.

Factors affecting portfolio performance

Tuesday, February 21, 2017

By Michael McCarthy

How do you build your investment portfolio? I’m not asking about the mechanics of the process, or the adviser you work with. What’s your philosophy? What sort of activities will give your portfolio higher returns over the long run?

There’s no single, right answer to this question. Our individual needs, goals and experience mean that personal characteristics such as risk appetites and investing time frame must come into consideration. Nonetheless, there are a number of key choices that all investors face.

1. Asset allocation

Many studies and academic papers over the years wrestled with an important investment question. Which decisions most affect portfolio returns? Although there is still room to argue, many come to the conclusion that asset allocation is the most influential. That is, it’s not the individual share, deposit or property chosen, but how the portfolio is split among these asset classes. The first decision investors should make is how they will divide their investments among shares, property, bonds, cash and other asset classes such as commodities and collectibles. 

A generally accepted principle is the longer the investor time frame, the more risk. Truly long-term investors have the ability to wait out market storms and potentially capture higher returns. 

In asset allocation this means a greater weighting towards shares. Investors with shorter time frames and lower risk appetites are likely to favour more capital stable investments like cash and bonds. 

2. Portfolio selection

Once investors have guidelines for asset classes it’s time to think about individual investments in each asset class. Although I invest in both, I’ll leave the property and bond markets to those engaged full-time. 

Cash is the ultimate capital stable investment but it carries a significant and often ignored risk. Underperformance. Receiving 1-3% returns when others are earning 5-20% is devastating to wealth over the longer term. 

3. This brings us to share portfolios.

Naturally, most investors look to buy high-quality stocks cheaply, while taking advantage of the risk reducing power of diversification. Seems straight forward, BUT, we don’t all agree on what constitutes high quality, and the only way to be sure of buying at low points is with hindsight. 

In broad terms, an important differentiator is whether investors build their portfolios from the bottom up, or the top down. Building from the bottom up usually means identifying stocks that are cheap or undervalued, and buying them with a view to long-term appreciation. Conversely, top down investors decide the type and style of portfolio they believe best suited to conditions, then seek individual stocks that meet the criteria.

Neither style is right or wrong. Investors with a distinct investment profile will probably maintain a style over the longer term. Other more adaptable investors will adjust their style to the conditions. Both approaches involve risk. Investors who never change may be caught in extended periods of underperformance, where their investment preferences remain out of fashion. Investors who change too regularly face increased cost and exposure to whip-sawing.

Identifying the appropriate stocks is made easier by the proliferation of tools available to individual investors. Almost all top tier online brokers offer their clients software that will scan the market for stocks that fit investors’ criteria.

Fundamental scanners can be set to find stocks with multiple parameters. A bottom up investor may search for stocks with a market capitalisation above $100 million, a dividend yield higher than 5% and a P/E ratio below 12. A top down investor may seek a stock in a particular sector that has upwardly revised earnings and positive price momentum. Whatever the investment style, a fundamental scanner can vastly reduce the search time.

Similarly, some investors use a technical analysis scanner to identify opportunities. One investment use of a chart scanner is to scan for more reliable patterns on longer term chart. A search for double bottoms and reverse head and shoulders formations on weekly charts can identify stocks breaking upward from lower trading ranges, potentially alerting investors at the early stages of a rally.

Investors face many choices. One involves technology. An investor can rail against the rise of algorithmic trading, or chooses to embrace the new world. In the age of a technological arms race, staying up to date with the latest tool scan be as important as staying up to date on the market.

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Common behaviours that could hurt your investments

Tuesday, February 14, 2017

By Michael McCarthy

I’m about to toss an Australian $1 coin. One toss only. Pick one - heads or tails. Now, take a piece of paper and write the number one, and put an “H” or “T” next to it, depending on your choice. 

Before I toss the coin, consider the following. This is not the first toss of the coin today. In fact, I’ve flipped it four times, and this is the fifth toss. The results of the four tosses were: H, T, H, H. Before I toss for the fifth time, write the number two on your sheet of paper. Now, put an “H” or a “T” next to it – your choice in light of the new information. You may stick to your original choice, or move to the other.

Behavioural Finance is the study of real human decision-making, rather than the classical economic model’s human that is a “rational agent maximising utility”. Theoretical rational economic agents always make the most efficient economic choices. Meanwhile, here in the real world, we see investors make decisions that clearly take non-economic factors into account. In some cases, investors appear to act against their own best (economic) interest.

There are many causes of these uneconomic decisions. Take a look at your sheet of paper. If the letters next to the numbers one and two are different, your second choice is subject to a “framing error”. On any given coin toss, the probability of Heads or Tails remains equal, no matter what has occurred beforehand. Any investor that changed their decision based on the additional framing information did not act rationally.

If you changed your choice, don’t be downhearted. You merely demonstrated that you act like a human being. And framing errors are just one of the information processing errors that investors make every day. Other investor challenges include hindsight bias, confirmation bias, herd behaviour, gamblers’ fallacy and anchoring errors. 

Another clear distortion of investor behaviour is experiential learning. This is the tendency we all have to give greater weight to our own experience. Where that experience is positive, it reinforces the behaviour. This may explain why so many Australian investors remain overweight financial stocks. On the other hand, a negative experience leads to avoidance. Many studies show that the impact of negative experiences is greater than the effect positive experiences.

This brings us to the Great Financial Crisis. The GFC, in most cases, had a huge negative impact on investors. The scars of that experience can be traced in the investment decisions of today.

This table shows, in broad terms, the asset allocation of SMSFs from 2004 to 2016. Each of the coloured bars represents a year, and the percentage of SMSF funds invested in that asset class for that year:

Source: ATO

The experience in shares shows investors’ responses both mirror and lag their responses. The purple bar is 2007. Note how the percentage of SMSF funds dropped away sharply post GFC. Share holdings hit a low point in 2009 – the bottom of the market (“be greedy when others are fearful”). Since then, shareholdings have increased but are still nowhere near pre-crisis levels. This is one of the scars of the GFC, because the numbers tell us that over the long term, shares offer the best risk-adjusted returns.

The debt shows similar fluctuations in risk appetites. Holding cash and bonds is considered less risky than other asset classes. Not surprising, this asset class saw strong flows after 2007, moderating as conditions slowly improved. 

The stickiness of property investment is harder to rationalise. A flight to “hard” assets is understandable in the aftermath of the GFC. While not rational, investors believe there is intrinsic value in assets like property and gold, and part of this esteem is the ability to touch the asset. Many investors equate tangibility with lower risk. This is despite the fact that it was largely plummeting house prices that sparked the global rout. The fact that this bias continues to show in SMSF asset allocation as a whole is another scar from the GFC.

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Can the 'Goldilocks' economy keep the bears away?

Tuesday, January 17, 2017

By Michael McCarthy

Investors locally and globally are enjoying a Goldilocks moment. Share prices are buoyant. Markets are collectively expressing the view that the global economy is “not too hot, and not too cold”.

Not hot enough to spur sharp interest rate rises and stimulus withdrawal, not cold enough to spiral into recession and crises. One of the key investment challenges in 2017 is deciding how long conditions can remain “just right”.

Positive signs

The recent data from the USA is unambiguous. The economy is clearly improving. Growth in China defied the “hard landing” sceptics in 2016, coming in at 6.7%. Two of the three major engines of the global economy are in better shape. Europe remains a concern, as an anchor dragging on the global economy and as a source of systemic risk, but there are no signs of deterioration from current low expectations. 

This means the outlook for the global economy, and the bobbing cork that is the Australian economy, is modestly positive. However, significant risks remain.

The election of Donald Trump and the second-look perception that his populist policies will boost the US economy is dominating market thinking heading into the presidential inauguration on January 20. Additionally, monetary conditions are at their most accommodative, despite the interest rate increases from the US Federal Reserve. The Bank of Japan and the European Central Bank are still pumping away, supporting global asset prices, and the Fed appears nowhere near withdrawing its more than $3 trillion injection.

US S&P 500 Index

 

Given the underpinning of the largest monetary expansion in history, and an improving global growth outlook, it’s hardly surprising that share prices are hitting highs. In countries like Australia and Germany, the major indices are at better levels than at any time in 2016. In the UK and the US, share markets are at all-time highs. These highs come despite a litany of woes – slow European growth, unstable Italian banks, credit fears focussed on China, trade wars and currency impacts, among others.

Is it sustainable?

The answer is yes and no. The reason for the seeming contradiction is that the increasingly conflicting central bank flows as the Fed moves toward withdrawal, combined with fragile sentiment, will potentially mean further bouts of surging volatility. Although asset prices could rise, the path is likely jagged, with huge moves fuelled by investor sentiment swings. And periods between moves may be unusually quiet.

This volatility of volatility increases difficulty for those unprepared. Calm patches may lull, and subsequent moves terrify. Professional traders will search for “fat tail” events, those highly unusual market moves that inflate the extremes (tails) of the distribution curve.

Additionally, a sleeping dragon is stirring. Current concerns about inflation are centred on the lack of it. However, the US core inflation readings are at 2.1% pa, above the Fed’s 2.0% target. Unemployment is well down on post-GFC highs, underemployment is dropping and wages growth hit 2.9% p.a. at the latest read. The uptrend in both indices is clear.

If the newly elected President and Congress administer an economic sugar hit, bottlenecks could quickly appear. Acceleration in wages growth from current levels would quickly feed into an inflation burst. This could force the Fed’s hand on interest rates, and make current estimates of two 0.25% rate hikes in 2017 look dangerously conservative.

The worst case scenario is inflation breaking out and productivity growth remaining moribund. Stagflation is still quite low on most economists’ list of risks. A further uptick in inflation could change perspectives very quickly.

The rhetoric from Trump Tower is short on detail for any stimulus plans, or anything other than a southern border wall. Many commentators are cautious about the outlook for the Asia Pacific region given the potential for a Trump inspired trade war. Risk awareness is important, but few are focussing on the potential gains for the region. China’s pivot to Asia over the last decade could mean many are overestimating the strength of the US position in these negotiations. After all, the major economy with the strongest growth is China, not the US.

The defensive positioning of Asia Pacific markets, including Australia, contrast with US exuberance. These could see a sustained period of outperformance from local share markets. Lower currencies and the potential for further falls against a strengthening USD add to the argument for an overweight position in Asia Pacific equities.

Additionally, anything less than an out-an-out trade war should see the recent improvement in commodity prices continue. This should lend additional support to stock markets that have significant resource component. In a world of opportunities, sometimes the best investments are close to home.

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How to invest in 2017

Tuesday, January 10, 2017

By Michael McCarthy

The Australian share market is off to a great start to 2017. Anticipation of Trump-inspired stimulus in the US is driving commodity and share prices higher. Despite an easing of bond yields, and some support for gold, it is apparent that risk appetites around the world are higher.

The high water mark for the Australia 200 index in 2016 was 5,699. On the first day of trading in 2017, the market sliced through this point and has not looked back. The index has a perfect record, with gains on all five of the trading days so far this year.

While this is encouraging, investors will no doubt recall the damaging sell off that began in early January 2016. From a purely behavioural point of view, this makes a sell off this year less likely, as the fresh memory of the painful market moves means many investors are positioned much more defensively. 

Another factor to consider is that five days is a very short time in markets, and the moves may eventually prove themselves just noise. Investors contemplating the outlook for the year may start with the big picture. The weekly chart for the last ten years is a good starting point:

On the left is the GFC sell down that extended from 6852 in November 2007 to 3120 in March 2009. These are the lines in the sand – any trading above or below these points would be highly significant. Although there are large swings along the path, the overall bias in the market since 2011 is upward, and that bias is evident since the February 2016 low. The up-trend is now through resistance at 5600 and, on balance, many will consider a test of 6000 likely in the short to medium term.

Despite this positive bias, high levels of risk remain. None of these major threats may come to pass, but still demand consideration. US political risks, weak Japanese and European growth, potential credit crises in China or Europe and possible inflation outbreaks are in the mix. None are new, and none have occurred yet. However, the experience of the past five years is that markets may inflict large amounts of self-inflicted damage in anticipation of one of these, or other, risk events.

This combination of factors mean investors seeking superior returns cannot afford to miss the up-trend, but must prepare for regular sentiment induced swings in market prices. The red line at the bottom of the chart is the realised volatility of the market. After the spike in Q1 2016 it has settled back, but remains above the lower levels of 2013/14. In my view, this is the low point for volatility for the year, and market moves will pick up in size and speed.

What’s an investor to do?

The response will depend on individual circumstances. There are a number of potential strategic responses, but it is clear they must prepare for a year like 2016 again.

Buy and hold is in my view an unlikely winner in 2017. Instead, the rewards are likely to go to active investors – those who are prepared to take advantage of the anticipated market swings.

Active approaches may include selling out good gainers to buy back in at lower levels. This may apply to a single shareholding, a proportion of a portfolio, or the whole portfolio. Alternatives include taking asymmetric risks with options – holding cash and buying call options or holding a portfolio and buying put options.

Further, investors may hold their portfolio throughout the swings, while managing their exposures with CFD position over the index and/or individual stocks. 

Alert Switzer readers have seen this before. That’s no accident. Investment plans, and investment strategy, are longer-term approaches, and change only with important changes in market conditions. My opinion is that 2017 will be like 2016, only more so. That is, there will be a central, modest improvement in overall market levels, but the path to those high points will be even more volatile than last year.

ImportantThis content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Who’s afraid of the big bad Fed?

Tuesday, December 13, 2016

By Michael McCarthy

The US Federal Reserve will announce its interest rate decision at the conclusion of the FOMC meeting early on Thursday morning, Australian time. The investment world is watching. A quarter percent lift in rates is the overwhelming consensus. The almost certain rise means the focus turns to the “dot plot” – the board members’ estimates of where rates will sit in the future.

The previous estimate from the Fed board pointed to two more 0.25% increases in interest rates over 2017. That is, the cash rate will be 1.00-1.25% by December next year. This is in keeping with comments from Chair Janet Yellen and other voting members that the trajectory higher for interest rates is “gentle and gradual”. Obviously, the Fed board is just as concerned about damaging a fragile economic recovery as the most pessimistic commentator.

Why does this matter to Australian investors? Let me count the ways.

Interest rates

A rising interest rate environment in the US means Australian rates are more likely to increase. This is driven by direct and indirect effects. International investors are naturally attracted to higher returns. To stay competitive for investment, Australian rates may also have to rise. This is playing out in bond markets, where the yield on ten-year bonds keeps hitting new multi-year highs. From lows at 1.81%, the rise hit 2.86% yesterday, and shows no sign of reversal.

Currency

One of the effects of a higher interest rate regime is that it attracts investors – and they must buy the local currency. Higher US rates will almost certainly mean a higher USD. Most of the effects that are relevant to the Australian economy are transmitted through changes in currencies.

The flip side for a rising USD, is a falling AUD. A lower local currency makes Australian goods more attractive to US buyers, allowing the local economy to import demand, and with it inflationary pressures from the US. While the immediate stimulus from this anticipated activity is currently most welcome, it may eventually lead to the Australian economy’s next big issue – inflation.

The impact on shares is less straightforward, as different aspects of an increasing interest rate environment push in opposite directions. Higher borrowing costs are bad news for business. Additionally, discounted cash-flow valuations (DCF) have a heavy reliance on interest rates. As rates rise from zero in many countries, the impact on analysts share price valuations is negative and immediate.

Alert readers may point out that despite the lift in longer-term US rates occurring in anticipation of this week’s decision, US share market indicators are hitting all-time highs. The cost and valuation impacts are still relevant, but US investors are possibly responding to the broader economic improvement that is driving rates higher. 

The Fed needs a stronger economy to unwind the easy money conditions it created in response to the GFC. The fact it is prepared to continue the process now, after a 12-month pause, is a signal to investors that the US economy is in better shape. This signalling aspect of central bank action is well studied, and much analysis shows that, in broad terms, share markets rise for approximately the first two years of interest rate increases.

The big risk

So far, so positive. An improving US economy and its rising share market are good news for Australian investors. However, the rising USD may also bring the largest headache. As the USD rises, those with managed currencies have allowed a depreciation of their local currency. The USD has risen from 6.0 yuan to closer to 7.0 yuan. This appreciation in USD/CNH makes goods from China more attractive to US buyers, and US goods less attractive to buyers in China.

And that’s the problem.

US domestic politics, in seeming blind ignorance of the Fed’s $4 trillion dollar balance sheet, regularly kick around the “China is a currency manipulator” football. Forget the TPP trade deal, forget renewed US oil and gas production. US sabre-rattling over China may represent the biggest risk for Australian investors. 

The almost inevitable coming increases in US rates are yet another strand for investors to weave into their world view. The conflicting currents the environment creates will likely add to overall volatility. This further reinforces the need for investors seeking superior returns to act when markets move.

This is my last column for 2016. A happy Christmas and holiday season to all readers and the terrific team at the Switzer report.

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Market volatility demands action

Tuesday, December 06, 2016

By Michael McCarthy

“A rising tide lifts all the boats”

- apochryphal, often attributed to J.F. Kennedy

Remember the glory days of 2010 and 2011? All you had to do was own a stock portfolio – the rising tide of central bank monetary stimulus meant all the boats lifted (almost).  

Those days are long gone. The Australia 200 index is up just 2% for the year so far. However, the type of market was well flagged. One year ago, I looked at the performance of the market over 2015 and ahead to 2016 on this site:

“…there is a higher potential for the market to repeat its 2015 path, swinging between support around 4,800 and resistance at 6,000. A significant breach of either of these extremes would point to a new outlook, but the market is broadly sideways until then.

Therefore, the highest returns in 2016 will once again likely go to active investors – those who take advantage of market swings, cashing in good gains and buying when sentiment is sour.”

Further:

“While the index is sideways to down for 2015, underlying sectors were considerably more volatile. The Energy sectors shed more than 35% peak to trough, and Industrial stocks as a group are up 20% since January. Drilling down yields some extraordinary stock performances. Blackmore’s is up more than 400%, Slater and Gordon is down more than 90%.

These types of swings in an overall steady market mean the higher risk and reward profile of active investing could be attractive to former ‘buy and hold’ investors.”

 

The chart shows just how different market conditions are, by comparing the performance since the start of the year of stocks selected from 9 of the 11 official market sectors. This is the raw share price move. It’s expressed as a percentage, to allow comparison. In considering overall returns, investors also take into account dividend yields and any other returns, such as rights issues or special dividends. Nonetheless, it’s a fair snapshot of the performance of these stocks.

The first thing to check is the scale on the right. The best performing stock, Rio, is up 30%, and at one stage was up almost 50%. The hardest hit is Qantas, down 22% for the year, after recovering from a 35% drop. The difference in performance shows just how important it was to invest in the right sectors, and the right stocks.

Even within sectors, it was a difficult year. The consumer discretionary sector is a good example. An investor may have decided in June that consumer confidence and activity was growing, and sought an investment that benefited. A gambling or gaming stock? The investor may have chosen Tatts Group, and enjoyed watching the stock soar under takeover bid. Or Crown – and watched their investment crumble as market doubts about Crown’s China strategy hit the share price.

Many of the events that drive stock prices are unpredictable. Diversification is a reasonable approach to managing individual stock risk. Investors with narrowly spread portfolios most likely had a volatile year. 

The good and bad news is that 2017 promises more of the same. A modestly positive economic outlook accompanied by significant global risks. Threats from Europe, from the Americas, and sentiment a key driver of market action. Adding to the mix is the now conflicting stances of central banks, as the US Federal Reserve lifts rates while the Bank of Japan and European Central Bank continue to accommodate. This could see volatility increase even further, adding to the call for an active approach to markets.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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3 market hurdles in the silly season

Tuesday, November 29, 2016

By Michael McCarthy

Melbourne Cup day is the official start to the silly season, which traditionally stretches until Australia Day. There were days when Australian investors could effectively switch off for summer. However, the demands of the globally interconnected investment world means clocking off for that long is risky, and this year there are events that demand attention.

Naturally, markets are through the first of the silly season events – the US election. Despite the election of the candidate markets feared, shares are higher. There is a spreading view that “president-elect Trump” is a much more careful and stimulatory leader than “candidate Trump”. All four major US share market indices hit new highs, industrial commodities soared, and gold and US bond markets have rolled over. 

We’ve talked before about the improvements that arrived under cover of the noise of the US election (3 things you missed during the US election circus). In summary, the economy in China moved further ahead, higher priced market darling shares came back to earth, and Australia’s big four banks all reported solidly, if dully.

Adding to the positive momentum for local investors is the strength in commodity prices. Normally, this would bring a higher AUD. While the little battler is higher versus JPY and EUR, it’s lower against the rising USD. This is a powerful combination for Australian resource shares, lifting earnings and at the same time making share prices look cheaper to international investors.

With these factors in place, there must be a reasonable chance of a Santa Claus rally, surely? The answer is “yes, but”. The “buts” are hurdles the market needs to jump, and the upcoming OPEC meeting, the Italian referendum and the US Federal Reserve interest rate decision are all on the investment radar.

Many headline writers attribute the recent oil price rises to a potential OPEC agreement to cut production. While it’s important to welcome newcomers to the employment markets, only inexperience should allow journalists to reach that conclusion. OPEC production limits are usually observed in the breach.

The best case scenario for those looking for higher oil prices is that OPEC and various members will make statements that an “historic agreement” is in place. OPEC production plummets immediately and oil prices leap. Over the next year, OPEC production creeps higher, back to levels above the original cut. In the meantime, more agile producers jump back into action, hedge their anticipated production, and OPEC faces more competition than ever. 

In other words, oil prices are likely stuck between $40 and $50 a barrel, with potential to spike to $55 occasionally. Despite this essentially sideways outlook, commentators will continue to forecast doom and boom based on that day’s oil price. Investors may see opportunities where short term swings are due to extreme thinking on energy prices. Investor take-away; much ado about nothing. Take advantage of any short term impacts.

On December 4, the Italian people will vote on sweeping electoral reform. Proposed by the PM Matteo Renzi, proponents argue the reforms will streamline political decision making. However, fears of a Brexit style vote against, and possible implications for the European Union, are causing some investors heartburn. Investor take-away; a vote “for” is a modest positive. A vote “against” is a potential market disaster, although considered unlikely. Then, again, so was Brexit …

The US Federal reserve Open Market Committee meets for the last time this year on December 13-14. A 0.25% rise in interest rates is now baked in. Assuming this is the case, the market will simply move-on, after a careful examination of the dot plot – the FOMC members estimate of where interest rates will be at the end of 2017 and 2018. Investor take-away; a 025% rise is now the neutral path. A failure to lift or a 0.5% rise would rattle markets. Possible reactions are highly unpredictable.

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ASX 200 could reach 5900 by year's end

Tuesday, November 22, 2016

By Michael McCarthy

The 31st of December is fast approaching. The Australia 200 index is up just over a 1%, with a dividend yield including franking around 5%. The experience in individual stocks has been much more volatile, but this modestly positive impulse expressed by the index gains should mean most diversified investors have done “okay”.  

With a month to go, what are the prospects for further gains, or a slip to lower returns?

This daily chart shows the steps the market needs to clear to break higher or lower. No-one can state the future with certainty, but an examination of the more probable scenarios may inform investor thought and action as market activity wind down into the Christmas/New Year period.

Although sideways moving markets often frustrate investors, one upside is they can provide a clearer view of key inflection points for the broader market. Where there is plenty of market activity at a price level, there is higher visibility of the collective decision of the market. 

Chartists sometimes disagree about which support and resistance levels are more important. There is art as well as science to technical analysis, so the lines on the chart above represent my view on the matter.

The first factor to note is that the index is currently sitting close to the middle of the two year trading range. The overhead resistance at 5385 (lowest red line), and the way the market index behaves if/when it approaches this level is the likely first indication of the market direction into the end of 2016. If the index fails at this level and starts moving down, many would suggest downward momentum and a potential test of the lows closer to 5050.

On the other hand, a push up through 5385 could have investors cheering. This kind of positive move could set the scene for a Santa Claus rally, with an initial target around 5725. 

A move into either the highest or lowest zones defined by these support and resistance levels seems less likely. However, one of the lessons of the last few years is that almost anything is possible. Current measures of short term volatility indicate the average (mean) daily move is 1%. Six or seven straight days of a single direction would see the index break into these end zones. 

For this reason I’m sticking to my year end call of 5900, if somewhat nervously. While a number of factors will need to fire, it is still an attainable level for the index. Reasons for investors to be cheerful include:

The Trump sentiment turnaround

The market response to the president-elect’s acceptance speech is a remarkable change. The Dow Jones Industrial Average gyrated through a 1050 point range in a single 24 hour session. Climbing from the pre-speech lows to close at the high, the markets showed a clear preference for president Trump over candidate Trump. This perception that the new US administration will prove positive for the local and global economy must remain in place if the index is to move higher.

Ironically, this means the US Federal Reserve needs to go ahead with its mooted interest rate rise at its December 13/14 meeting. While higher interest rates hurt share valuations, the signalling effect of the Fed pressing ahead, and the implied confidence in the US economy, would more likely support higher levels for share markets despite the valuation impact.

A falling AUD is another important potential contributor to a higher share market in Australia. The slip below 0.7400 US last Friday night may see a test of the recent lows near 0.7150. Naturally, a lower AUD makes local shares cheaper for global investors. Further falls in the currency could bring international participation to any rally.

Finally, commodity prices must maintain, or build on, current levels. Support for mining and energy stocks is an important component of market strength. If iron ore holds above US $60 a tonne, and oil above US $40 a barrel, the commodity exposed sectors will likely continue to see support.

It’s a lot to ask that four important and supportive conditions remain in place, or indeed improve. However, it does occur and this sort of blue sky could see the Australia 200 index spare yet reach heights few dare to predict.

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The chart every investor must see

Tuesday, November 15, 2016

By Michael McCarthy

Investors’ time horizons vary enormously. Those spending the kids’ inheritance have a different outlook to those saving for a retirement that is thirty years away. Yet, we all tend towards a similar timeframe when assessing market conditions of around one year. However, there are times when it’s important to understand market moves from a longer-term perspective.

Step up, US ten-year bonds.

For the last thirty-five years, US bonds were in a bull market. In 1981, the ten-year bond yield hit a high at 15.84%. Although it wasn’t in a straight line, yields dropped over the intervening years to hit a low at 1.36% in July this year.

This is one of the most extraordinarily sustained trends seen in any traded market. 

The main drivers worked hand-in-hand to lower interest rates over the decades. After the excesses of the 70’s, central authorities around the globe were determined to “fix” inflation. The damage to economies and personal wealth from rampant inflation brought a strong focus. Policy makers adjusted fiscal and monetary structures to drive inflationary pressures lower. A local example is the wages accord struck between the Hawke-Labor government, businesses and unions that tied wage increases to productivity gains.

Just as this initial assault on inflationary forces started to fade, the digital revolution kicked in. The rapid growth and spread of new technologies brought enormous, one-off productivity gains to most industries. This increase in productivity didn’t flow only to wages. Profits increased and deflationary price pressure further dampened inflation and expectations, leading to even lower long-term interest rates.

Of course, the final kicker to lower yields was the quantitative easing policies enacted by central banks around the globe. This unprecedented accommodation and the historic levels of liquidity pushed bond markets to extremes, with many European issues trading at negative interest rates. 

This is not a history lesson. The point for investors is that the 35-year rally is showing clear signs of ending. The US Federal Reserve lifted rates from their lows last December, and is likely to lift rates again this December. This hike, and Republican control of the US congress and the White House, are two important reasons for a sea change in interest rates. And the price action is confirming the shift:

 

This weekly chart shows the last decade of trading in the price of ten-year bonds. As interest rates fall, bond prices go up. The most recent up trend that began in early 2014 is clearly broken. While the US Fed is adamant that the normalisation of US interest rates will be gradual and gentle, the direction is now down for bond prices, and up with interest rates.

What does this mean for investors?

Rising interest rates hurt asset prices generally, and share valuations in particular. However, this should not bring fear to investors’ hearts because the reason interest rates are rising is that the underlying economy is improving. Naturally, these conflicting currents can produce market turbulence, but they are not the outright negative espoused by uber-bears.

However, it is time to start re-balancing portfolios away from defensive earnings (property trusts, consumer staple, utilities, infrastructure, healthcare) and towards growth (energy, materials, industrials). Banks sit in the middle of these groups, and whether investors should buy or sell financial stocks depends on the current composition of their portfolios.

There are further considerations. Active investors are best placed to earn superior returns under prevailing market conditions. While the tectonic shift in interest rate markets is important, picking the right stocks remains critical. Secondly, staying engaged and responding to price changes will continue to drive returns. In simple terms, this may involve locking in good gains in one stock to buy another at a better value point. More sophisticated investors may use CFDs and options to provide an “overlay” exposure.

Whatever the choice, staying active is the key.

ImportantThis content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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3 things you missed during the US election circus

Wednesday, November 09, 2016

By Michael McCarthy

After the most unusual US election campaign in living memory, the day of decision is finally here. Markets will work their way through the result, with a focus on implications for global and US growth, trade and potential US Federal Reserve action. However, the US is not the only factor global investors must consider. And while all eyes were on the North American circus, there were a number of developments of high importance to Australian investors.

The data in China is positive

While you were watching the Trump shuffle, central authorities in China are reporting a modest expansion. Of particular note were manufacturing PMIs. Both the official and private indices moved firmly into expansion territory. Retail sales are growing steadily at an annual rate around 10.5% pa, and industrial production continues to increase at around 6% pa.

The trade data is of particular interest. While exports slipped further, imports rose, despite further devaluation of the Chinese Yuan. China bears immediately seized on the slip in exports as sign of further slowing of the economy. However, this contradicts the clear evidence of a steady state in Q3, with GDP expanding at better than forecast 6.7%. 

Another interpretation of this data is that the desired and predicted transition of the economy in China is occurring – consumer demand is rising as the industrialisation process slows. Once the election is out of the way this better-than-expected outlook for China may seep into the global investing consciousness. 

Industrial metals such as iron ore and copper are soaring – and Australian listed mining stocks are still trading at discounts to valuations at current spot prices.

Market darlings were bashed

High growth, high Price-to-Earnings ratio stocks fell to earth. As investors took risk off the table, these former favourites *ahem* “underperformed”.  If CSL, Dominos and REA Group (among others) are on your long-term shopping list, now is the time. Give these a once over before the market wakes up.

Combining these two themes, if Bellamy's, Blackmores and Bega Cheese are on your market shopping list, there are compelling reasons to check current prices.

Banks reported

The big four reported over the last fortnight (CBA quarterly, the rest annually). The picture is muted – growth in loan books remains lower, and profits went backwards as cost and margin pressures emerged. On the positive side, bad and doubtful debts remain under control and capital ratios are healthy ahead of increased requirements next year.

The financials index (excluding property) is still around 10% off a one-year high, despite a recent rally. Dividend yields in banks look more attractive than 1.5% cash rates. Add franking, and lower share prices, and the case for higher cash flow blue-chip share investment gains momentum.

In other words, while we were all wondering if US politics could get any more bizarre, the investment world is moving on. Many of the recent events obscured by the campaign are positive for Australian shares – miners, high growth stocks, higher dividend yielding stocks. 

These groupings capture around two-thirds of the major market index, establishing a “ground up” case for a rally into the year end.

ImportantThis content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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