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The Experts

Michael McCarthy
+ 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.

Milk bubbles?

Tuesday, June 20, 2017

By Michael McCarthy

The “b” word is thrown around a lot. China credit? Bubble. US S&P 500? Bubble. Australian housing market? Bubble.

We are now at the point where any solid rise is labelled a bubble. Yet, the characteristics of a bubble are well studied, and most of the markets so labelled do not display them.

Key characteristics of bubbles include a suspension of disbelief. Alert investors listen up for newer versions of “it’s different this time” as a sign a market could be about to pop.

The second characteristic is identified on a chart: a strong and sustained price rise that steepens exponentially.

A2 Milk (A2M) added to its lustre with yet another profit upgrade last week. The New Zealand-based dairy producer pushed revenue estimates up and advised it will invest some of the additional income in marketing, although less than previously advised this year. 

Naturally, the shares rose. However, the way they rose is a problem. 

The daily chart shows the price rises are getting steeper. The most recent buying has pushed the gains to almost vertical. Those who believe the share price action is primary evidence could be very concerned by this action. This looks very much like a “blow off” phase that precedes a bubble bursting. 

So far, I haven’t detected any “it’s different this time” arguments around a2M. Another possible, but in my view less likely explanation for this dramatic and explosive stock move, is that it is step-changing to new, higher valuations.

However, the instability implied by the gapping higher may see prudent investors locking in at least some of the recent gains.

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JB Low-Fi?

Tuesday, June 06, 2017

By Michael McCarthy

Standing on your desk and shouting “Amazon is coming!” is not stock analysis. Yet, some investors appear to take this approach to their investments. The big sell-down in retail stocks in anticipation of the entry of stiffer competition is indiscriminate. It’s reasonable for investors to wonder if any babies have been thrown out with the bath water.

In my view, the answer is an emphatic yes. There are retailers in Australia with strong earnings records and a history of responding well to evolving retail environments.

Although I put Harvey Norman in this category, today I’d like to focus on the numbers that give confidence JB Hi-Fi has hit an attractive share price level.

1) The PE ratio

PE ratios are much abused. They are easily misused, and in some sectors such as resources, have little application. However, in retail they are a useful ready reckoner on the value in a stock. This chart shows JB Hi-Fi's PE ratio against its share price. When JBH hit its all-time high in February this year, the PE ratio remained well below its historic highs. This reflects the growth in earnings over time.


After the sell-down, the PE is closer to historic lows. At around 12.5x, JBH looks cheap to me. 

2) The dividend yield

Currently 6.7% when franking is included. The current cash rate is 1.5%. 

Despite threats, the consensus among analysts is that JBH will grow at around 9% (according to Bloomberg). Higher dividend yields are rare among high-growth stocks.

Recent headlines may have investors concerned that there is universal bearishness about JBH, yet three analysts rate it a “Sell”, six a “Hold” and five a “Buy”.

3) Key support at $22.60

This chart shows the bounce of support around $22.60. There are no guarantees in markets, but this combination of factors may give investors the confidence to trade through the market noise.

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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Is the market set for a pullback?

Tuesday, May 30, 2017

By Michael McCarthy

Global share markets are testing investors’ nerves. The German DAX and the US S&P 500 are at record highs. The Nikkei and the Australia 200 index are at post-GFC highs. Markets have clear positive momentum. Yet, event risks over the remainder of the year are high, and valuations are stretched. Buy, sell or hold?

Investors can draw comfort from data this year which shows European expansion, an upswing in the US and stabilising growth in China. The better outlook reduces the potential for a market meltdown.

However, there is an argument that current share market levels are reflecting an “as good as it gets” scenario. Among other factors, if the White House can’t deliver its stimulatory measures, if the European economy stalls, if the upswing in growth data doesn’t flow through to wages, there is potential for substantial corrections.

If a global fall of 10-20% is on the cards, how will local stocks fare? The short answer is badly. More experienced investors can take advantage of the historically low levels of volatility and use derivatives to cover downside risks. Other investors face selling down stocks to reduce any impact of a market stumble.

Which stocks will suffer most in a downturn?

In a low growth environment, companies that grow profits at levels well above the systemic rate command a premium. Think Domino’s Pizza, Sydney Airport and Bega Cheese. The reasons vary, but the share price premium is reflected in the P/E. Ratios in the 30x to 45x range are common.

Healthcare as a sector falls into this category. Leaders such as CSL, Cochlear and Fisher and Paykel have PEs in the 30x-40x range. Ramsay and Resmed are trading at around 25x earnings. The demographic theme of an aging population requiring increasing health services in a sector where the government pays the bills is an attractive investment proposition. The PE premium attached to the sector reflects investors paying up for assured growth and income.

The problem is the crowding into these exposures. The investment themes are well known, and the PE premiums demonstrate the popularity of these stocks. These elevated valuations could be harbingers of underperformance in a market sell-down. Not only are they caught with most other shares in any downdraft, they may suffer a larger P/E contraction than the broad market, meaning a greater fall in percentage terms. This is how market darlings become fallen angels.

The nature of the pullback

The nature of the pullback is an important consideration. A short sharp sell-off that sees investors bargain hunting fairly quickly would most likely see these premium stocks continue to trade at higher multiples than the broad market. However, a gut-roiling market panic could see investors selling what they can. In this sort of sell down, premiums tend towards defensive earnings (Woolworths, anyone?) and away from growth.

In my view, any stock market correction is more likely a healthy pullback than a crisis. Regardless, a broad market fall of 10-20% could see some stocks and sectors drop further. Reliable income streams could be more highly valued than projected growth rates. Investors may wish to examine portfolios for vulnerabilities before any serious selling starts.

In the past eighteen months, share market rewards went to stock pickers and active investors. Willingness to take advantage of market swings in both directions has been an important value creator. For this reason, investors should welcome a pull back as an opportunity to generate excess returns. As the chart shows, a pullback for the Australian share market may be very close:

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Wild Western Areas

Tuesday, May 23, 2017

By Michael McCarthy

Share market index volatilities are at, or near, century lows. This could mean that individual stocks are also quieter, OR, it could mean that individual stocks are swinging more wildly, but the swings are offset by stocks moving in the opposite direction. For an example of the latter, look to nickel sulphide miner, Western Areas Ltd (WSA).

Classic Historical Volatility measures the change in share price from one day to the next. Both 90- and 180-day volatility in WSA are close to 60%. In contrast, the same readings for the Australia 200 index are 9.2% and 11.2%. WSA is far more volatile than the market average. There are good reasons for these larger daily fluctuations.

Not only is WSA in the volatile commodities space, it’s a nickel miner. Nickel is, of course, a major component in stainless steel production, and the largest consumer of seaborne nickel is China. This makes WSA somewhat of a proxy for Chinese steel consumption, and broader China sentiment. Given often vehemently opposing views on the outlook, it’s no surprise that WSA is highly volatile.

Readers of refined sensibilities and lower-risk appetites should look away now. Because there’s broad agreement the near- and medium-term outlook for nickel is constrained. Nickel spot prices are off more than 10% from 2016 highs, and China bears abound, despite being horribly wrong about a “hard landing” for at least five years.

Now have a look at the WSA chart:

First, note the share price is down around 40% on 2016 highs. Secondly, no matter how I draw the down trend line, the price is clearly breaking up through it. The price action is unambiguously bullish. Thirdly, WSA is the second most shorted stock on the ASX, with a whopping 17.5% of all shares sold short. 

Despite the current pessimism, the WSA share price is signalling upward, and the large short position creates the potential for a melt up in price if momentum catches. This could be important news for both longer-term investors and short-term traders. 

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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Retail tales: The Amazon effect and JB Hi-Fi

Tuesday, May 16, 2017

By Michael McCarthy

The “Amazon effect” - an increasingly mystical and omnipotent threat to every retail operation in Australia - is on its way. Judging by share price action, both Harvey Norman (HVN) and JB Hi-Fi (JBH) are particularly vulnerable. Yet just as the track record of Australian companies expanding overseas is less than glittering, the local landscape can, and does, trip up international operations expanding in Australia.

In the 1980’s, many lessons were dished to young traders in Australia’s newly opened money markets. Market structures and practices were new and fluid. The standard transaction size in foreign exchange markets was $1 million. In an attempt to dominate the market, one of the newly arrived US banks boasted they would “do the world in ten”. That is, they would make forex prices to buy or sell $10 million to anyone who cared to ask. 

That was a stunning upping of the ante, and many local traders feared for the outlook for Australian participants, worried this big North American outfit would take over the forex markets. However, it’s clear in hindsight that there was a profound cultural misunderstanding. Locals had (and still have) a particular disdain for big-headed show ponies. Every trader sought to pick off the braggarts. Within six months, the Big American had downgraded its Australian operations and sent the head forex trader off to Hong Kong.

Australians sometimes place too much emphasis on commonality with other English speaking nations, and forget there are very real cultural differences. Starbucks’ experience in Australia is a case in point. After stellar success in the USA over the 80’s and 90’s, it started an international expansion. In 2000, Starbucks arrived in Australia. 

Many feared for the 6,000 plus independent cafes in Australia. However, again there was a cultural misunderstanding. Starbucks' success in the USA was at least in part due to the previously widespread sale of fairly ordinary drip filtered coffee, and Starbucks’ revolutionary use of espresso coffee. The situation in Australia was very different. Waves of post-war European immigration brought with them a more sophisticated coffee culture.

Starbucks initially expanded to almost 300 stores. However, Australians knew what good coffee tasted like and the strategy didn’t work. Starbucks started selling stores. In 2014, a final shedding reduced Starbucks’ presence in Australia to 22 stores, with accumulated losses greater than $140 million. Despite stupendous success in other markets, Starbucks’ Australian venture was a failure.

The idea that Amazon is about to sweep the Australian retail landscape clean is the extreme – the reality will take longer, and likely have less impact than the extremists think. It may even fail. This brings us to the sell down in JBH and HVN. Both of these groups have demonstrated their capability and adaptability over decades. The recent 20% plus sell off in both stocks brings their P/E ratios down to 12-13x, and both stocks are sitting on share price support levels.

In short, they are top quality retailers at attractive valuations. This sort of window rarely stays open for long.

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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Stock in the spotlight: Adding growth exposures

Tuesday, May 09, 2017

By Michael McCarthy

Markets near high points present challenges to investors. One problem is caused by the need to re-weight a portfolio as conditions change. Finding a performing stock to sell is straightforward. Determining which stocks to buy when valuations are full to expensive is more difficult.

Alumina Ltd (AWC) is an unusual stock in that it has only one asset – a 40% stake in Alcoa World Aluminium and Chemicals (AWAC). AWAC is a global miner and smelter of bauxite and aluminium, and has operations on four continents. 

Aluminium producers fell out of favour in a carbon-constrained world because they consume huge amounts of power in the production process. However, the world still needs aluminium and the spot price has rallied more than 30% over the last eighteen months as confidence in the industrial outlook grows.

At $1.70, AWC remains well below its all-time high above $7.00. Some analysts are concerned about the dividend outlook, as first quarter payments from AWAC dropped below the required run-rate. In my view, this is a timing issue, and AWC is likely to increase its dividend again. A scenario where industrial activity swings higher and inventories run down is supportive of a higher Aluminium price, and a more profitable AWC. 

Investors underweight resources and looking to add growth-exposed stocks may find AWC a suitable choice.

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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Stock in the spotlight: Going for Platinum

Wednesday, April 26, 2017

By Michael McCarthy

Share markets around the world are at or near post-GFC highs. Finding good value in shares is a tougher-than-usual ask. However, there are still opportunities for investors. “Fallen angels” are one such source of potential value, and a celebrated value investor may, in itself, represent good value.

Active mangers (stock pickers) are under pressure at the moment. Current market conditions have favoured momentum and growth strategies. In a seeming contradiction, defensive investors have performed on the back of strong dividend yields. Generally speaking, active returns are lagging index returns, putting them at the bottom of the fund manager pile.

Platinum Asset Management (PTM) has had a poor run. To some extent, this is driven by the tougher environment for value investors. Sticking to its bottom up, individual company based approach demonstrates their discipline, but has hurt returns. In 2016, profits fell 6% and funds under management dropped more than 15% as investors shied away.

Clearly, the returns generated by different investing styles are cyclical. At some stage, value investors will return to the top of the heap. Investors committed to buying high-quality businesses at lower share prices are likely looking at PTM right now.

Note the action at $4.85 (green line).Repeated bounces of this level make it an important support. It may also mean longer-term investors are conducting “back-foot” buying campaigns. Chartists refer to this as a basing pattern, and it supports the idea that the share price has found a low.

At current levels, PTM is trading on a PE ratio of around 16:1, well down from the highs around 26:1. The dividend yield (including franking) above 9% is also an attractive proposition. In my view, this value manager is good value.

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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Climbing the wall of worry: 3 events that could derail the market

Wednesday, April 19, 2017

By Michael McCarthy

The Australian share market is threatening the ceiling. Recent positive moves put the 200 index at the highest point since the devastating sell down of 2008. Positive fundamental factors are somewhat balanced by extensive event risk over 2017. The direction of the market over the coming months will be determined by investor reactions at this crucial level. And events scheduled over the rest of April could determine that reaction.

The all-time high for the Australia 200 index occurred on November 1, 2007 at 6,852. The post GFC-low occurred on March 9, 2009 at 3,121. It took the next six years to recover to levels a shade below 6,000, spending almost six weeks between March and May 2015 attempting to penetrate that level before falling away. Now, the index is back at 6,000 (give or take) and investors are faced with the same challenge. Are the recent gains sustainable? Can the market trade higher, or will it pull back once more?

The RBA board again reflected on the improvement in the international outlook at its most recent meeting. Stabilising growth rates in China, an accelerating US economy, expansion in Europe and signs of traction in the Japanese economy are positives for the local economy, and therefore shares. So far, so good.

However, there are significant events over the course of the year that could derail a modestly positive outlook. Three occur before the end of April.

US reporting season

The US reporting season represents a particular threat. Recent outperformance over US shares by the Australian bourse is a long-awaited positive. But local investors should not become complacent. If the US market sneezes, Australian investors will catch a cold.

The problem with the US reporting season revolves around lofty expectations. According to Bloomberg, the consensus forecast across the top 500 companies is earnings growth of 9%. Although this is lower than previous estimates closer to 12%, it is high compared to the two quarters of negative earnings reported last year. Admittedly, the US economy is in a sweet spot. Growth is accelerating, but interest rates are still historically low and wages (read corporate costs) are contained.

Nevertheless, the big miss on March non-farm payrolls (98,000, forecast 180,000) suggests potential downside risk. A number of economists were unconcerned, explaining that weather factors played a role. If weather affected jobs growth, it may also weigh on company profits. Although the season kicked off last week with J.P. Morgan and Citigroup, the likes of Johnson & Johnson and Yahoo this week may provide a better guide to the overall economic outlook. If US investors are spooked by what they see, a slide in share market sentiment may infect all regions.

The French election

The first round of voting in the French election occurs on April 23. The leading candidate, Le Pen, and the fastest riser, Melenchon, are both seeking a referendum on France’s membership of the EU. A Frexit is a much greater market concern than Brexit. France is in monetary union, and is the second largest economy in the EU. A departure is an existential threat to the Union.

Naturally, should either the hard left or the hard right gain ascendancy in the four runner field, investors are likely to dump shares and ask questions later. 

The announcement of a snap UK election in June merely adds to the uncertainty. However, given the fact of Brexit, the threats here loom largest for the UK, rather than the global economy.

CPI data

Finally, there is the Australian CPI data released on April 26. At the moment, analysts are divided on the direction of interest rates. Some expect further cuts in the second half of this year, some are looking for rises. The shockingly low read on inflation for Q2 2016 was a dominating factor in the RBA rate cut of August. Market thinking around this read on Q1 inflation is a continuation of the recent uptrend and an 1.5% annualised rate of inflation.

A number well below the forecast will bring immediate calls for further rate cuts, and could be supportive of share prices. On the other hand, an annual rate approaching 2% would take cuts off the table, and could batter the market.

None of these risks are a given, and of course, developments over the second half of April could see further gains for shares. A sustained move over the 6,000 index level would be a strongly positive event.

However, it’s clear risks are rising. The Australian volatility index has lifted from all-time lows below 8% three weeks ago. While still not at historically high levels, this sort of move is usually due to one or both of two factors - increased demand for portfolio insurance, or professional traders bracing themselves. Either way, Australian investors should take note.

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A beef with P/E ratios

Wednesday, April 12, 2017

By Michael McCarthy

Price to earnings ratios (P/E Ratios) can be misleading. Usually, they look at the next 12 months’ earnings only. If a company is in the midst of a strategic transformation that will deliver benefits beyond the one year window, the P/E may look much worse than the real prospects of the company. This brings us to the Australian Agricultural Company (AAC).

AAC’s shift is driven by a desire to turn from price taking to price making. Traditionally, larger agricultural producers tended towards commodity production, seeking scale to drive higher profitability. However, producers of commoditised goods are at the mercy of the market. If they refuse the market price, any other producer of the same goods can, and will, take their market share.

On the other hand, producers of niche and premium products have much more control over the prices they charge. This is the philosophy underpinning AAC’s investment in its beef herd and the creation of the premium Westholme and Wylarah brands in October last year. At its November results announcement, AAC claimed the largest Wagyu herd in the world.

Naturally, these products speak directly to the “pure food” thematic that global investors seek in NZ and Australian food producers – from Manuka honey to infant milk formula. Yet, the disruption of the ban on beef exports to Indonesia started a long period of underperformance. The silver lining is that this ultimately led to the new approach to AAC’s product range.

The increase in price swings on the long-term chart point to market interest in this strategy. The current P/E for AAC is around 31 times. However, Bloomberg consensus estimates of 2019 earnings suggest at current share price levels a P/E closer to 17 times, and in 2020, a mouth-watering 8 times. Tactically, investors may attempt to pick up AAC close to the $1.60 support, with a back-up plan to jump on board on any move above $1.75.

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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Going for growth

Tuesday, April 04, 2017

By Michael McCarthy

The Australian share market burst through previous highs last week. The strength of the market took many by surprise, including this writer. In one of those market ironies, the strength is at least partly a result of defensive positioning, leading to a melt-up where investors scrambled to top up their portfolios. Investors pondering what to buy could turn to the energy sector despite highly volatile oil prices.

Defensive share portfolios are a fact of post-GFC life. Healthcare stocks are popular for their assured income streams as populations age and governments pay the bills. More assured income streams also make utility and property stocks desirable. Dividend yield stocks such as banks and telcos are over-represented in portfolios as they allow investors to receive income as they ride-out any market storms. 

The reverse is also true. Investors are generally underweight more growth exposed stocks, such as miners and industrials. Many investors weigh the potentially higher returns from these sectors against the higher risk, and opt for safety. However, this ignores another investment risk – under performance. Whether tilted too far to defensive stocks, or heavily overweight cash, investors without growth exposures will lag their peers in an accelerating growth environment.

Some investors are well advanced in a portfolio rotation to growth. They saw the low points of 2016 as the bottom of the commodity cycle and bought resource shares. While many resource stocks are well off their lows, there is still potential upside, especially if commodity prices keep tracking the global economy higher.

This brings us to the energy sector. Oil and its derivatives power the world. Despite the rise of renewable energy sources - and the desire to move to a carbon dioxide reduced environment - there are no viable replacements for cool and coal so far. The one form that can compete, nuclear energy, is politically unpalatable.

After the high volatility of Q1 2016, oil prices have recovered. The charts show a price range for WTI crude, with major support around $42 a barrel and resistance at the recent highs around $56. There are fundamental factors supporting this range. Above $50 a barrel, US shale producers spring into action. Below $45, many producers are unprofitable and OPEC gathers support for limiting supply. While there is an element of elasticity to these reactions, they are likely to contain oil prices for some time.

This top side limit is sowing the seeds for the next oil boom. Major investment in exploration and drilling is unlikely while this perception remains. Large US inventories and desperate national producers mean this is probably years away, but it will surprise markets when/if it occurs. 

Perhaps more important is the potential for LNG. Gas is cleaner to burn and much cheaper to produce than most other energy forms (coal is the cheapest and dirtiest). It’s why, in my opinion, gas is the answer in a carbon-constrained world. And it's why I favour Oil Search and Woodside in the Australian energy sector.


This chart tracks the performance of Oilsearch, Woodside and Santos over the past eighteen months. The background is the oil price. Over the period, the price of oil is up 20%, yet the performance of these three key energy stocks is wildly disparate. Oilsearch is up 16%, Woodside is close to flat and Santos is down 26%. 

This difference in performance is partly attributable to individual company factors. An investor’s choice between these three could reflect different investment approaches. Some may argue that Santos is a value proposition, given it’s under performance. However, I prefer Oil Search as I see it as a higher-quality play. Woodside is also one of my favoured picks, but may face risks from politicians looking to plug budget deficits.

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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Stock Spotlight - Healthscope (HSO)

The triple top: Is the market set to slide?

Are shares at risk of a pullback?

Gold for Australia: stocks to watch

Reporting season: the good, the bad and the ugly

Factors affecting portfolio performance

Common behaviours that could hurt your investments

Can the 'Goldilocks' economy keep the bears away?

How to invest in 2017

Who’s afraid of the big bad Fed?

Market volatility demands action

3 market hurdles in the silly season

ASX 200 could reach 5900 by year's end

The chart every investor must see

3 things you missed during the US election circus

Could Trump sink your portfolio?

Healthcare stocks catch a cold. Time to sell?

This week's jobs numbers could make or break the market

Will there be a Santa Claus rally?

Should you buy the banks?

Active investors are cheering, not panicking

Why should Aussies care if the Fed raises rates?

Pay close attention! Market action could heat up

How to energise your portfolio

How to know if your company is a winner

Rate cut or not, stocks could climb

Is the market in the sell zone?

Is the share market ready to surge?

Australian shares and the federal election

Investors need to stick with a strategy

Flight Centre has its wings clipped

What every successful investor needs to know

Sell in May and go away?

Share investors are currency traders

Buying stocks in choppy markets

Any value in Woodside?

Media under the Southern Cross

ANZ: forecasting disaster

Blowing housing bubbles

Australian shares back in the zone

Investment approaches in volatile markets

The not-so-big Australian

Signs of a market bottom

Slaying golden goose myths

Investment strategy and the reporting season

Good news for rational investors

Tightening tales

The upside of low energy prices

Australian shares: looking ahead

Energising your portfolio

The wisdom of copper

How will rising US rates impact your investments?

News versus noise

The investment toolbox

The three-stock portfolio

Digging for gas bargains

How to keep your investment cool

“Dow 30,000 Now” and CSL

Canberra puts a Buy on shares

Market volatility and dividend floors

Dusting off the portfolio

Market routs, corrections and sell offs

Share market falls and CBA – time to buy

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