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The Experts

Michael McCarthy
Expert
+ 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.

Stock Spotlight - Healthscope (HSO)

Tuesday, March 28, 2017

Healthscope (HSO) is unusual in its sector. Healthcare stocks are generally well supported, with top quality companies like CSL, Cochlear and Ramsay enjoying status as core holdings in many portfolios. In contrast, HSO is trading near its all-time lows.

The reason is a fall in earnings as an ambitious building program is rolled out. Earnings and profits fell at the last half year report, again unusual for the sector. Interest costs and depreciation both rose, reflecting the capital expenditure. However, a number of these projects are due to come online this year.

This sees analysts estimating long term growth at around 20%. At current levels the Price to Earnings ratio is around 20x giving a juicy PE/G ratio close to one. There are significant risks here, not least management’s ability to deliver large construction projects on budget and on time. In my view the share price close to the low of $2.12 makes this a risk worth taking.

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The triple top: Is the market set to slide?

Tuesday, March 21, 2017

By Michael McCarthy

Things look good. Markets are up, and the medium- to long-term economic outlook continues to improve. There’s proof in central bank activity. However, the short-term direction for share prices is less positive. Fundamental factors and technical indicators are pointing to a possible market pull back and opportunity for investors.

Both the US Federal Reserve and the People’s Bank of China are obviously confident enough in the underlying strength of their economies to tighten monetary policy. The US is lifting rates, and in China borrowing is tougher. Recent growth and activity data is positive and trending upward. Strength in these two nations is enough to shift the global view.

Even the president of the European Central Bank is leaking hints that the era of accommodation is coming to an end. Given the amount of event risk this year in Europe alone (Brexit, major elections, etc) this is an expression of high confidence. Much better manufacturing and services indices that speak to an ongoing economic expansion underpin the confidence.

However, one plus one does not always equal two. An improving outlook does not necessarily mean a higher share market – at least in the short term. The reason is straightforward. Stock prices accord to the future, not the present. As the numbers late last year started to show stabilisation in China and an accelerating improvement in the US, share markets around the globe reacted. 

The rise reflected optimism that arguably included benefits from new US policies. These potentially stimulatory moves are still in the offing, and US markets in particular appear to carry little risk premium for potentially economically damaging mooted trade barriers.

This means we have a US S&P 500 index trading above historical norms, around 20 times earnings. In Australia, the index P/E ratio is less stretched at approximately 16-17 times, but not cheap. And the seasonal positivity associated with the October to April period is coming to an end.

Now, take a look at the technical picture:

The index has approached levels just above 5800 on three occasions this year. On each occasion, it has failed to break through. The initial double-top formation could now evolve to a triple top, with the three peaks already in place.

Naturally, if this is a triple top the index may fall substantially, with targets at 5500, 5150 and 4850. This is my base case – the scenario I think most likely. It’s why I’m a buyer of index put options, which increase in value as the market falls. 

How will the market prove me wrong? There are two scenarios. The first is if the market climbs the wall of my personal worry, bursting through the recent high at 5832. A daily close above that point is bullish, and negates the triple top formation. That sort of action would see traders looking for a test of 6000 in fairly short order.

Secondly, the market may trade sideways, maintaining the current lower volatilities. A narrow range between 5600 and 5832 would mean little in the way of overall opportunities, making portfolio construction almost purely a stock-pickers’ game. In my view, this is the least likely scenario.

The Australian volatility index (AVIX) hit an all-time low last week. Confidence or complacency are riding high. Periods of low volatility don’t last for ever, and can come to end in a step-change for markets. A possible source of a sudden shift in market thinking is the bond market. A recent rally back in bonds and gold suggest not all is well. If rising interest rates spark a rout in US bonds, the sentiment impact could be strongly negative.

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Are shares at risk of a pullback?

Tuesday, March 14, 2017

By Michael McCarthy

The Australian share market could be facing a significant pull back. While fundamental economic conditions continue to improve, there is growing evidence that market pricing has run ahead, and will need to correct itself. How do I know? The chart.

It seems amazing that market participants still fall into the “fundamental analysis versus technical analysis” trap. After all, they are not mutually exclusive. When trying to solve a puzzle as complex as the market, why wouldn’t an investor use all the tools available? 

Charts can give hints and warnings of possible price moves as, or even before, the fundamental factors become apparent. Possible is a key word here. No indicator (or fundamental factor) has a 100% record in forecasting market moves. If an investor accepts the idea that the price of any share is simply a mass expression of opinion, it’s easy to understand the difficulty in forecasting. Crowd behaviour can be as beautiful as a ballet, as brutal as a riot. And crowds and markets can flit from one to the other very quickly.

At the moment, the chart of the Australia 200 index is flashing a warning:

An experienced investor or trader may pick up this chart and shout “sell” immediately”. Let’s work through the process.

Starting at the beginning, this is a daily candlestick chart. Each of the (pink or blue) candles represents one day’s trading. A blue candle means the day closed higher than the opening. A pink candle is a down day. For most of 2016, and into this year, the index is in an uptrend – signified by the purple line that touches the ongoing series of higher daily lows. 

The green line at 5580 is a point where the index has found support and resistance previously – and is therefore more likely to do so again. The break through that level signalled potential for further gains. So far, so good.

However, the problem occurs when I run CMC’s pattern recognition scanner for “double tops”. The thinking was to identify market indices in the US that were clearly signalling a pullback. Instead, the Australia 200 index showed the orange double top signifier – the extended “M” shape you can see on several peaks in the chart.

Because no signal is fool proof, traders often look for confirmation. Often, this is another unrelated indicator that is pointing in the same direction. At the bottom of the chart is the MACD (moving average convergence divergence) which is a multi-use indicator. There are two lines to the MACD. The black line leads, and the red lags. Signals occur when they cross – sell when black crosses from above, buy when black crosses from below. 

However, there is more to the MACD. Where the cross occurs relative to the middle “zero line” is important. A sell signal above the line is considered more powerful, as is a cross upward below the zero line.

Now back to the chart. The MACD is threatening to cross upward, usually good news. However, the lines are above the zero line, and a touch and fall away is as good as a cross from above. In other words, a couple of negative days trading and it’s likely the short term traders will start heavily selling the index.

Keeping perspective, a 5% pullback to around 5500 would leave the longer term uptrend intact. A normal and healthy pull back that creates a base for further gains. On the other hand, chart signals can be as wrong as any expert. In trading above the recent high at 5832 would negate the double top and shift the balance of probabilities to more immediate gains for the market

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Gold for Australia: stocks to watch

Tuesday, March 07, 2017

By Michael McCarthy

Australian listed gold stocks are notoriously volatile. One explanation is that many day traders use them as a proxy for trading the yellow metal. The larger volumes and bigger daily ranges are both a product of trader participation, and a cause of that participation. In a year where event risk is elevated, investors may consider adding gold stocks to the portfolio as a hedge against market disruption.

The all-time highs of the US markets appear to reflect optimism that the new administration will both stimulate and support economic growth. Many of the measures foreshadowed will do exactly that. Corporate tax cuts are one example. However, other policies could have a negative impact. Any moves that curtail trade are likely to hurt the country enacting them, as well as the countries targeted. 

At a PE of 20, the US markets can be compared to an overinflated balloon, and no-one can say with certainty whether the balloon will slowly deflate, or pop. Policy announcements that lower growth forecasts could do either.

Heightened political risk is an issue in Europe as well. Elections in the Netherlands take place next week. French voters will go the polls in the next two months, and German officials face a ballot in September. The rise of populist parties means ambitious would-be politicians may be tempted by policies with strong electoral appeal, regardless of known potential economic consequences.

Given the potential for politics to roil markets, gold is on the radar. Some may prefer to trade gold directly, using instruments such as CFDs. Others may prefer to buy coins or bullion. The appeal of assets that can be held in the hand is well established. 

Investors with significant portfolios could turn to listed gold mining and producing stocks, while staying out of the junior explorer space. There is a risk that even gold producing stocks may not rally if there's a market meltdown and spot gold prices rocket higher. There are no guarantees. 

Bearing in mind the risks, two stocks are high on my list. Newcrest (NCM) is the largest listed gold stock on the ASX. With market capitalisation around $16 billion and operations in Australia, Africa and across the Asia Pacific region, some may see it as the safer play:

Given the volatility of the sector, a good entry level is more important than usual. My plan is to wait for a move back to the zone between $16.35 and $18.00.

One stock that reported better prospects is Northern Star (NST). An all in cost of production between $1000 and $1050 make it profitable at current prices, and the company said it's on track to produce 485,000 to 515,000 ounces this year. Some analysts expect the production to come in at the top of that range:

Once again, I’m cautious on entry. I’d prefer to see NST somewhere between $2.97 and $3.50 before stepping up to the plate.

My view is that the most probable scenario is the modestly positive economic prospects will see markets higher by the end of the year. Further, a strengthening US economy will bring Fed rate rises, a stronger USD and therefore, a lower spot gold price. It may seem strange to buy stocks and hope to lose. But that’s exactly where I’m at with gold stocks. I’m adding these to my list “just in case”, not because I like the outlook. If there are no market disruptions my portfolio overall should prosper, and if something does come from left field, my gold stocks will help.

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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Reporting season: the good, the bad and the ugly

Wednesday, March 01, 2017

By Michael McCarthy

Solid sales growth and a bounce back in overall profit are two key takeaways from the company reports released over February. However, there was enormous variability between companies and sectors and some very strong market moves – up and down – following individual company results. 

A feature for investors is increased dividends, particularly from commodity stocks. The top 200 stocks will pay $72 billion in dividends for the half year. The strength of mining earnings is remarkable, but other sectors showed increases as well, including healthcare, consumer services, financials and energy. This could see upgrades from analysts over the coming weeks.

So here’s my take on this reporting season. The following judgments are my opinions only. This is not a comprehensive look at all stocks, but merely those with results that caught my eye. I’ll start with the good, then move on to the bad and the ugly.

The Good 

There were a number of stand-out reports:

Bluescope Steel (BSL) shone. An 80% increase in net profit driven by a 200% lift in underlying earnings helped. Shareholders will receive a 33% larger dividend, and the management outlook for the second half of the year will show a 50% improvement over H2 2016. Which is just as well, given BSL’s share price doubled over the last nine months. Clouds remain over the long term outlook for the industry, but on valuation BSL looks cheap, trading at 10-11 times earnings versus the market average closer to 19-20 times.

Northern Star (NST) – the gold miner reported a 61% lift in net profit on lower costs and higher production. Not a fan of gold stocks generally, but the heightened risks of market disruption in 2017 may be a good argument for holding some gold exposures as a hedge against hard times. This is my pick in the sector.

While we’re in the resource space both BHP and Beach Petroleum (BPT) also reported strongly.

Cochlear (COH) and CSL both, once again, demonstrated why so many investors hold these top quality Australian companies as core investments. Serum sales surged at CSL, and Cochlear’s expanded product range drove earnings. Lofty valuations make it hard to bite the bullet and buy, and some investors will prefer to wait for a (relatively rare) pull back.

Selected retail stocks did very well. JB Hi-Fi (JBH - NPAT  + 16% and FY forecast +31-35%) and Harvey Norman (HVN – NPAT + 39%) justified strong share prices, with sector-beating results. Both presented strong evidence that they are superior retailers. Similarly, Nick Scali (NCK) grew H1 profits by 45%. The other eye-catcher is Super Retail Group (SUL), taking the prize with a 66% lift in half-year profit.

The problem with many of the stocks that reported so strongly is their share prices. These earnings turnarounds were heavily foreshadowed, and with the exception of BHP and BPT, most of the above are trading at, or near multi-year highs.

I’m looking for an earnings turnaround in a company with a bombed out share price and a valuation argument. Vocus Group (VOC) was hit hard last year, and saw several senior departures. Despite margin concerns as customers transition to the NBN, the company reported a 95% lift in H1 profit. The forward PE is around 12-13 times, and the share price is much closer to lows than highs. Additionally, there are a number of merger/takeover deals in the sector. This is the most likely addition to my portfolio as a result of reporting.

The bad and the ugly

There are a number of stocks that are at bombed out levels that may tempt investors. Bellamys (BAL) and Slater and Gordon (SGH) may be among them. However, in my view, neither showed signs of arresting share price slides that may be terminal. I struggle to make a bargain case here.

Post-result trading in APN Media and Fairfax (FXJ) were among the more curious market reactions. Both reported profit increases, a welcome relief to shareholders. The problem is that both saw the long established slide in sales revenue continue, raising questions about sustainability of profit and long-term prospects.

The most startling miss in my view is Brambles (BXB). The global logistics group saw profits slip 14%, despite exposure to the uptick in US economic activity. This provokes doubts about the strong rally in US shares – clearly not all companies are benefitting.

Seven Group (SVW) wrote down various costs and its SWM holdings, taking an underlying NPAT of 104 million into negative territory. While management talked up their portfolio of holdings, in my view the prospects for its main businesses remain constrained territory. Interestingly, SVW is trading near four-year highs. Possibly one for the short sellers to examine.

Rounding out the bad and the ugly is Iluka. It reported a $224 million loss and cut its final dividend. Write downs were a significant part of the loss, but underlying operations also delivered red ink. The best management could say about mineral sands markets was they saw signs of a fragile recovery. Not a buyer.

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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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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