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Ron Bewley
Market Expert
+ About Ron Bewley
About Ron Bewley, PhD, FASSA

Ron was Professor of Econometrics at UNSW when he was invited to join the Commonwealth Bank to found a Quantitative Research & Investment Strategy team. After researching across most asset classes in global markets, risk and strategy, he was appointed as the foundation Chief Investment Officer in CBA’s Private Client Services. He retired from the bank in 2009 and formed Woodhall Investment Research in the following year.

In his first book, Allocation Models, he presents a unified econometric approach for analysing relationships that allocate aggregates across their component parts - as in wealth being allocated across asset classes. He published over 50 academic papers on a variety of theoretical and applied econometric topics. He held a number of visiting academic positions in the US, UK and Europe. Ron was elected Fellow of the Academy of Social Sciences in 1995. He also consulted to a number of major companies and government departments.

At Woodhall, Ron has combined his academic and markets experiences to produce cutting-edge solutions for implementing investment strategies in equities and other asset classes.

Bubble, bubble, toil and trouble

Wednesday, February 27, 2013

What a difference a day (or two) makes! I started writing this piece on Tuesday 19 February - hence the title. I put all of the charts together on that day but I didn’t have time to write until today – and we ‘kinda’ know the answer now – or do we? What happens next? The charts are updated to the close of Friday the 22nd of February 2013.

I built a measure for market mispricing in about 2004 and developed ‘Version 2.0’ in 2010 when I formed Woodhall. So the results up to 2009 in this piece are reconstructed but the conclusions here are the same as I recall I made in real time. I publish updated results each week on our website. This paper serves to put the whole system in context and gives me more space to discuss what I think is going on now. And by the way, I archive all of the old Woodhall Weekly papers on the website for those who want to check up how I interpreted the results at the time.

Our thesis is straightforward. I believe the best source of information on the stock market’s future is contained in the consensus forecasts of dividends and earnings published by Thomson Reuters. We transform those ‘credible’ forecasts into forecasts of capital gains on the ASX 200 – and its 11 major sectors. If the market runs too hard compared to those forecasts, the market is increasingly overpriced. If the market falls behind those forecasts it is increasing underpriced. The skill in deriving this measure of exuberance is in how the benchmark ‘fundamental’ is constructed. That information is proprietary.

I show the daily history of exuberance measure in Chart 1. When the line is above the solid 0% line, the market is overpriced. Conversely, below that line the market is underpriced. The dotted line indicates 6% overpricing which, since 2005, has been our trigger point for a signal of an imminent correction of 6% - 10% or a prolonged sideways movement of the market. In the latter case, the market might remain at around some fixed level while the market fundamentals improve to erode the mispricing. As such, we do not believe that this measure constitutes a trading rule. Rather, it suggests when it might not be wise to buy and when it might be cheap. Importantly, we supplement this measure with our fear and disorder indexes – also available on our website. We have argued since March 2008 that when the market is fearful, the market can fall faster and stay lower for longer than when it is not fearful.

Chart 1: ASX 200 exuberance since 2002



What I see in Chart 1 is that, in the run-up to the market peak in November 2007, each time exuberance exceeded 6% market reaction was reasonably swift. At those times, fear and disorder were low and so there was not much over-reaction. As fear gripped the market from January 2008 the market did not recover as it previously had done – even though it was cheap by our measure. Our fear index got back to normal in early March 2009 when I ‘rang the bell’ on Switzer TV (Sky Business) to signal that the market was ready to climb back from its low of 3,146.  But the market enthusiasm was, in our opinion, so great that the market rose to 5,000 with major overpricing – and for an extended period. It took the market three years to break that local market high again.

In Chart 2, I show our standard chart which we publish in our Woodhall Weekly. Our market hit 6% on Tuesday, stayed there on Wednesday and got hammered on Thursday. I wrote in our weekly (February 16) that 6% was close but it need not end in tears as it seemed more like a repeat of money rushing in like 2009 than the pre-2007 peak days.

Chart 2: ASX 200 exuberance – last 12 month to the close on 21 February 2013



I think it is important to stress that we compute a comparable measure for each of the 11 major sectors of the ASX 200, as well as for the S&P 500 and its 10 major sectors. I believe the 6% rule seems to work uniformly across these 23 data series. However, markets, and sectors of markets do not necessarily move together. We had the S&P 500 overpriced by only 2.5% when we hit 6% this week and, as the snapshot of sectors of the ASX 200 in Chart 3 shows, there is major overpricing in certain sectors while Materials is actually cheap!

Chart 3: ASX 200 sectoral exuberance



Our argument for quite some time has been that money has been migrating from cash to defensive, high yielding stocks pushing prices to precarious levels. Before yesterday all sectors outside of Energy, Materials and Utilities were overpriced by more than 6%. A correction in those sectors should seem imminent but there are two mitigating factors. First, our fear, disorder and volatility are at low levels even for pre-GFC days. Second, investors who bought for yield are less likely to worry about absolute prices as those investors buying for growth. Interesting, the big sell-off yesterday hit resources harder than the overpriced sectors. Indeed, BHP and RIO fell in price on the open today while the market rallied 60 points before lunch!

In order to separate changes in exuberance due to price movements against changes due to the fundamentals improving, we have an alternative way of showing exuberance in Chart 4 - our Heat Spots map. Instead of drawing the ASX 200 price index as a line chart in the normal fashion we use a dot for each day. This change has minimal impact on data visualisation but when we colour-code the dots we can present a three-dimensional view of the market. We use red for ‘hot’ – when exuberance is more than 6% overpriced, ‘blue’ for cheap and green for priced at ‘par’. We split pricing between par and 6% into black for ‘warm’ and yellow for ‘high’.

Chart 4: ASX 200 heat spot map since 2002



It is hard to see the detail in Chart 4 and so we also present the same chart broken up into different sections by time to emphasise what typically happens when the 6% trigger is pulled. But before we turn to those charts the run-up in 2009 and the subsequent sideways movement is clear in Chart 4.

In Chart 5, it can be seen that the big bull market from the low in March 2003 to the first big correction at the start of 2005. Clearly there was not an immediate reaction as the dots turned red but the market did advance more than 1,000 points – around 30% - without turning red. It could do this because the capital gains forecasts that are central to our exuberance measure were sufficiently strong until the market crossed 3,500 and the rate of growth of capital gains increased.

Chart 5: ASX 200 heat spot map I



In Chart 6 we can see two corrections preceded by just a few red dots followed by a very intense period of red and a bigger correction.

Chart 6: ASX 200 heat spot map II



Chart 7 depicts the run-up to the all-time peak on November 1, 2007. Arguably, there was a lot of money going into super funds under the new ‘million dollar’ rule. Again there seems to have been valuable information at appropriate times uses the exuberance measure. Importantly, in this and preceding charts, there were seemingly ‘buying on the dips’ opportunities.

Chart 7: ASX 200 heat spot map III



Chart 8 highlights the intensity of the overly optimistic rally in late 2009 and the subsequent prolonged sideways movements.

Chart 8: ASX 200 heat spot map IV



Chart 9 takes us up to the close in business on Thursday 21 February. There were but two red dots before Thursday’s correction and that was followed by one yellow dot as exuberance was pulled back to under 4%. With the market up over 60 points at the time of writing on Friday lunchtime, another red dot is not far away!

Chart 9: ASX 200 heat spot map V



So is this a bubble waiting to burst? By our measure it is certainly a bubble but it may not burst for the reasons stated above. It could well be like pricking a balloon though a piece of sticky tape stuck to it. It just deflates slowly and more by sideways market movements as the fundamentals improve following a pretty decent reporting season. We have fair pricing of the market at about 4,800 with an end-of-year target of about 5,200 based on our broker-based forecasting method. We have an alternative long-term pricing model that makes 5,400 a possibility for year end. And how will it get there? Not in a straight line but the market is currently settled and so the future looks not too bad from here.

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Woodhall's Wall Street Connections

Wednesday, May 02, 2012

The S&P 500 lost 0.8 per cent and the ASX 200 gained 1.4 per cent over April. This small disconnect, in part, allowed both markets to finish the month with about the same degree of mispricing - around +1 per cent. This level playing field makes going forward easier for our market. Earlier in the year, the S&P 500 was flirting with levels that could have caused a correction while the ASX was priced at par. Now both markets could rise another five per cent quickly without their being a flow-on correction from the US to the ASX.

The prospects for both markets remain strong. The ASX 200 is expected to grow by 15.20 per cent over the next 12 months with a 5.9 per cent expected dividend yield (excluding franking credits). The S&P 500 is expected to grow by 11.57 per cent over the same period with an unfranked dividend of 2.3 per cent.

Our fear indexes got a little out of step in the second half of April. The US variant kicked up while ours remained at very low levels. The VIX came down to about 17 per cent at the end of April. Since 90 per cent of VIX observations lay between 11 per cent and 20 per cent in the bull market period (March 2003 - June 2007), conditions in both markets are promising for a continued rally.

One disturbing feature of this note is that both the one-year and five-year probabilities of default for Western Europe have kicked up sharply with the one-year probability rising to a level not seen since the GFC. 

There is no doubt that both the US and Australian economies are softer than most would like. The US is ready to act through the Federal Reserve introducing QE3 if necessary. The Australian Government is tackling the problem from a different direction. It is tightening fiscal policy so as to produce a small surplus in the hope the Reserve Bank can cut rates to counteract fiscal policy and resuscitate an already ailing economy prior to the May 8 budget.

The marked fall in the volatility of the ASX 200 and certain sectors has produced a scenario for sector rotation (see Woodhall's Quant Quarterly). However, these forecasts do not take the putative budget into account.

Charts 1 and 2: Each point on each line represents a 12-month ahead forecast of total returns or dividends starting from the date on the horizontal axis. The forecasts are constructed from broker forecasts of dividends and earnings for each company in the index, then aggregated up to sectors and then to the market index. Thus, the first forecast on the left of each chart started twelve months ago and finishes today. The right hand point is for the next 12 months starting today. Since the S&P 500 forecasts were updated monthly until June 2011, the blue lines are horizontal between updates up until June 2011.



Charts 3 and 4: These charts are based on the information used to compile the forecasts for the most recent day by sector and market.


Charts 5, 6, 7 and 8: We take the forecasts of capital growth in Charts 2 and 4 to determine where the market should be priced. A necessary assumption of our method is that these forecasts are credible. The ratio of the actual price index to the point we estimate the market should be located measures mispricing. Charts 7 and 8 present the most recent data and, for reference, where mispricing was estimated to be one week earlier. We have previously determined that +6 per cent can be a useful indicator that the market or sector is sufficiently expensive to cause a correction or to stay flat while the fundamentals improve to eroded mispricing. We have never been able to establish a trading rule based on this indicator but it often serves to indicate good entry and exit points for long-term investors needing to rebalance a portfolio. We have also found that expensive markets tend to fall faster and further when our fear and disorder indexes are high. Conversely, cheap markets seem to stay cheap long when fear and disorder are high.


Charts 9, 10, 11 and 12: Historical and forward price-earnings ratios are similar to those usually calculated. However, we use the relevant earnings estimates to be those consistent with the ones we derive for use in our total returns forecasts. The main difference between our method and traditional methods is that we attempt to provide a more timely estimate of earnings for the current day and going forward.



Charts 13 and 14: The VIX index is the standard 'fear' index that is based on options pricing for the S&P 500. At Woodhall, we have defined a fear index that is based on recent intra-day movements in each of the price indexes. Our fear statistic is a measure of excess or irrational volatility. We have argued elsewhere that our fear index tends to lead the VIX and the Australian equivalent.

 



Charts 15 and 16: The ratings' agency, Fitch, analyses the probabilities of default for a variety of bonds in several regions of the world and combines them into a regional index. Action by the debtor can change the outcome so that these probabilities are estimates of what might happen in the presence on inaction.

For more from Ron Bewley, head to http://www.woodhall.com.au.
All data are sourced from Thomson Reuters Datastream.

Important information: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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Woodhall's April Wall Street Connections

Wednesday, April 04, 2012

Key points

The S&P 500 gained 3.1 per cent and the ASX 200 0.8 per cent over March making the year-to-date gains 12 per cent and 6.9 per cent, respectively. For the ASX 200, the market is still about fair-priced but with some big some across sectors. Materials is severely underpriced at -6.9 per cent, IT is above the trigger point for a correction at 6.6 per cent and Health is close to it at 5.8 per cent. Industrials, Discretionary, Financials and Utilities are each about three per cent overpriced. On the S&P 500, the market is more than three per cent overpriced with IT at levels still suggesting a possible correction for that sector. No sector in the US is even moderately cheap. Financials, Health and Discretionary are all expensive.

Prospects for both markets have steadied over the last month with the ASX 200 expected to outperform the S&P 500 by about three per cent over the coming 12 months with total returns for the ASX 200 expected to be about 20 per cent.

The ASX 200 has been in great shape since the start of the year. Fear, disorder and volatility are at levels common before the GFC started. The S&P 500 has been playing catch-up in this regard. But the VIX got below 15 per cent for a day or two during March.

The probabilities of default for both North America and Western Europe have steadied for both the one-year and five-year horizons.

Copper prices and Brent Oil held steady during March. WTI Oil, Gold and the CRB commodities index each fell by about four per cent. Silver fell by 13 per cent.

The biggest danger to both markets is the S&P 500 exuberance climbing from its current 3.3 per cent to the 'correction trigger point' of six per cent. Such a breach might also have implications for Australia. Of course, the recent sideways tracking of the S&P 500 around 1400 wouldn't be a bad thing for us if that continued while we play catch-up as we did in the last few days of March.

US data – particularly consumer-related – remains strong but Australian data is a bit soft. The big question for Australia is whether the China slowdown story has been oversold. Today's PMI might give the ASX 200 a boost but some are saying it was only high because of seasonality. Some are never happy. It seems to have been priced into the ASX 200 Materials sector.

All data are sourced from Thomson Reuters Datastream.

Notes for Charts

Charts 1 and 2: Each point on each line represents a 12-month ahead forecast of total returns or dividends starting from the date on the horizontal axis. The forecasts are constructed from broker forecasts of dividends and earnings for each company in the index, then aggregated up to sectors and then to the market index. Thus, the first forecast on the left of each chart started twelve months ago and finishes today. The right hand point is for the next 12 months starting today. Since the S&P 500 forecasts were updated monthly until June 2011, the blue lines are horizontal between updates up until June 2011.

Charts 3 and 4: These charts are based on the information used to compile the forecasts for the most recent day by sector and market.

Charts 5, 6, 7 and 8: We take the forecasts of capital growth in Charts 2 and 4 to determine where the market should be priced. A necessary assumption of our method is that these forecasts are credible. The ratio of the actual price index to the point we estimate the market should be located measures mispricing. Charts 7 and 8 present the most recent data and, for reference, where mispricing was estimated to be one week earlier. We have previously determined that six per cent can be a useful indicator that the market or sector is sufficiently expensive to cause a correction or to stay flat while the fundamentals improve to eroded mispricing. We have never been able to establish a trading rule based on this indicator but it often serves to indicate good entry and exit points for long-term investors needing to rebalance a portfolio. We have also found that expensive markets tend to fall faster and further when our fear and disorder indexes are high. Conversely, cheap markets seem to stay cheap long when fear and disorder are high.

Charts 9, 10, 11 and 12: Historical and forward price-earnings ratios are similar to those usually calculated. However, we use the relevant earnings estimates to be those consistent with the ones we derive for use in our total returns forecasts. The main difference between our method and traditional methods is that we attempt to provide a timelier estimate of earnings for the current day and going forward.

Charts 13 and 14: The VIX index is the standard 'fear' index that is based on options pricing for the S&P 500. At Woodhall, we have defined a fear index that is based on recent intra-day movements in each of the price indexes. Our fear statistic is a measure of excess or irrational volatility. We have argued elsewhere that our fear index tends to lead the VIX and the Australian equivalent.

Charts 15 and 16: The ratings' agency, Fitch, analyses the probabilities of default for a variety of bonds in several regions of the world and combines them into regional index. Action by the debtor can change the outcome so that these probabilities are estimates of what might happen in the presence on inaction.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

For advice you can trust book a complimentary first appointment with Switzer Financial Planning today.

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Woodhall's March Wall Street Connections

Friday, March 02, 2012

The S&P 500 gained 4.1 per cent and the ASX 200 0.9 per cent over February making the year-to-date gains 8.6 per cent and six per cent, respectively. For the ASX 200, the market is still about fair-priced but with some variation across sectors. Industrials and Discretionary are somewhat overpriced. Materials, Staples and IT are reasonably underpriced. On the S&P 500, the market is more than three per cent overpriced with IT at levels suggesting a possible correction for that sector. No sector in the US is cheap.

Prospects for both markets have strengthened over the last month with the ASX 200 expected to outperform the S&P 500 by about four or five per cent over the coming 12 months with total returns for the ASX 200 expected to be nearly 20 per cent.

After a prolonged period of 'fear' from the start of August to the end of 2011 both markets are now quite settled. Fear has been at pre-GFC normal levels for the ASX 200 since the start of December but S&P 500 fear only fell to similar levels during February as the Greek debt crisis was partially settled. Both markets should be able to absorb moderate shocks from here.

The exchange-rate-corrected ASX 200 continued to lag behind the S&P 500 (Charts 16 & 17) and that relationship seems to have ended in October 2011. Perhaps the markets will soon establish a new relationship.

The probabilities of default for both North America and Western Europe continued to fall for both the one-year and five-year horizons. The European woes continue to have less impact on our fates.

With copper prices up 11.9 per cent on the year, WTI and Brent oil price up 7.9 per cent and 16.4 per cent, respectively, commodity prices are strong. Of course gold prices fell sharply on 29 February to pull back gains for the month to only 0.2 per cent. Silver, on the other hand, rose 10.8 per cent on the month.

In the absence of any new source of bad news, both markets are in their best positions for a long time to produce a reasonable rally. The biggest danger seems to be the S&P rising too quickly in March to produce a correction or extended period of sideways movement!

All data are sourced from Thomson Reuters Datastream.

Notes for Charts

Charts 1 and 2: Each point on each line represents a 12-month ahead forecast of total returns or dividends starting from the date on the horizontal axis. The forecasts are constructed from broker forecasts of dividends and earnings for each company in the index, then aggregated up to sectors and then to the market index. Thus, the first forecast on the left of each chart started twelve months ago and finishes today. The right hand point is for the next 12 months starting today. Since the S&P 500 forecasts were updated monthly until June 2011, the blue lines are horizontal between updates up until June 2011.

Charts 3 and 4: These charts are based on the information used to compile the forecasts for the most recent day by sector and market.

Charts 5, 6, 7 and 8: We take the forecasts of capital growth in Charts 2 and 4 to determine where the market should be priced. A necessary assumption of our method is that these forecasts are credible. The ratio of the actual price index to the point we estimate the market should be located measures mispricing. Charts 7 and 8 present the most recent data and, for reference, where mispricing was estimated to be one week earlier. We have previously determined that six per cent can be a useful indicator that the market or sector is sufficiently expensive to cause a correction or to stay flat while the fundamentals improve to eroded mispricing. We have never been able to establish a trading rule based on this indicator but it often serves to indicate good entry and exit points for long-term investors needing to rebalance a portfolio. We has also found that expensive markets tend to fall faster and further when our fear and disorder indexes are high. Conversely, cheap markets seem to stay cheap long when fear and disorder are high.

Charts 9, 10, 11 and 12: Historical and forward price-earnings ratios are similar to those usually calculated. However, we use the relevant earnings estimates to be those consistent with the ones we derive for use in our total returns forecasts. The main difference between our method and traditional methods is that we attempt to provide a timelier estimate of earnings for the current day and going forward.

Charts 13 and 14: The VIX index is the standard 'fear' index that is based on options pricing for the S&P 500. At Woodhall, we have defined a fear index that is based on recent intra-day movements in each of the price indexes. Our fear statistic is a measure of excess or irrational volatility. We have argued elsewhere that our fear index tends to lead the VIX and the Australian equivalent.

Charts 15, 16, 17 and 18: We have argued that it is sometimes useful to consider our ASX 200 index valued in $US to aid comparison with the S&P 500. By so doing, we compare our market as a fully-hedged $US investor would see us. The ratio of the two US-dollar-denominated indexes in Chart 17 serves as a potential mispricing signal. The Australian dollar measured in US dollars is shown in Chart 18 for reference.

Charts 19 and 20: The ratings' agency, Fitch, analyses the probabilities of default for a variety of bonds in several regions of the world and combines them into regional index. Action by the debtor can change the outcome so that these probabilities are estimates of what might happen in the presence on inaction.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Woodhall's February Wall Street connections

Tuesday, February 07, 2012

Both the S&P 500 and the AXSX 200 enjoyed excellent returns during January. For a change, our index grew by 5.1 or 0.7 per cent better than the US. But these increases bring with them an erosion of the underpricing that was so prevalent during the second half of 2011. For the ASX 200, the market is now about fair priced with most sectors being close to that level. In the US, however, most sectors are a little overpriced. The S&P 500 is about two per cent over which is not alarming in itself but it might become a constraint soon.

We have argued that six per cent for exuberance can be the tipping point for a correction or an extended period of sideways movement. That would mean that another month of four per cent growth for the S&P 500 might stunt any further growth with a knock-on effect for the ASX 200.

Good longer-term growth is expected in both markets. For the next 12 months, the ASX 200 is expected to grow by 13.3 per cent, about three per cent faster than the S&P 500. Importantly, these rolling 12-months-ahead forecasts have strengthened during January. In the case of Australia, the gain has been two percentage points. (Stay tuned in coming weeks for Woodhall's Quant Quarterly which has more detail on the Australian market.)

Australian fear has been in the 'good zone' since 1 December 2011 (see Woodhall's Weekly for more details). The equivalent index for the S&P 500 has come down but retains some volatility. The VIX finished below 20 per cent for the first time since the August debt-ceiling debacle. Both markets are generally now reasonably calm.

The exchange-rate-corrected ASX 200 continued to lag behind the S&P 500 (Charts 16 & 17) although the gap has closed a fraction. It appears that the increased currency volatility from October 2011 may have broken this long-standing relationship.

The probabilities of default for both North America and Western Europe fell for both the one-year and five-year horizons. The European woes are having less impact on our fates.

The future seems to be more optimistic than at any time since June 2011 and maybe even earlier.

All data are sourced from Thomson Reuters Datastream.


 

Charts 1 and 2: Each point on each line represents a 12-month ahead forecast of total returns or dividends starting from the date on the horizontal axis. The forecasts are constructed from broker forecasts of dividends and earnings for each company in the index, then aggregated up to sectors and then to the market index. Thus, the first forecast on the left of each chart started twelve months ago and finishes today. The right hand point is for the next 12 months starting today. Since the S&P 500 forecasts were updated monthly until June 2011, the blue lines are horizontal between updates up until June 2011.

 

Charts 3 and 4: These charts are based on the information used to compile the forecasts for the most recent day by sector and market.

 

Charts 5, 6, 7 and 8: We take the forecasts of capital growth in Charts 2 and 4 to determine where the market should be priced. A necessary assumption of our method is that these forecasts are credible. The ratio of the actual price index to the point we estimate the market should be located measures mispricing. Charts 7 and 8 present the most recent data and, for reference, where mispricing was estimated to be one week earlier. We have previously determined that six per cent can be a useful indicator that the market or sector is sufficiently expensive to cause a correction or to stay flat while the fundamentals improve to eroded mispricing. We have never been able to establish a trading rule based on this indicator but it often serves to indicate good entry and exit points for long-term investors needing to rebalance a portfolio. We have also found that expensive markets tend to fall faster and further when our fear and disorder indexes are high. Conversely, cheap markets seem to stay cheap long when fear and disorder are high.

Charts 9, 10, 11 and 12: Historical and forward price-earnings ratios are similar to those usually calculated. However, we use the relevant earnings estimates to be those consistent with the ones we derive for use in our total returns forecasts. The main difference between our method and traditional methods is that we attempt to provide a timelier estimate of earnings for the current day and going forward.

Charts 13 and 14: The VIX index is the standard 'fear' index that is based on options pricing for the S&P 500. At Woodhall, we have defined a fear index that is based on recent intra-day movements in each of the price indexes. Our fear statistic is a measure of excess or irrational volatility. We have argued elsewhere that our fear index tends to lead the VIX and the Australian equivalent.

Charts 15, 16, 17 and 18: We have argued that it is sometimes useful to consider our ASX 200 index valued in US dollars to aid comparison with the S&P 500. By so doing, we compare our market as a fully-hedged US dollar investor would see us. The ratio of the two US-dollar-denominated indexes in Chart 17 serves as a potential mispricing signal. The Australian dollar measured in US dollars is shown in Chart 18 for reference.

Charts 19 and 20: The ratings agency Fitch analyses the probabilities of default for a variety of bonds in several regions of the world and combines them into regional index. Action by the debtor can change the outcome so that these probabilities are estimates of what might happen in the presence on inaction.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Woodhall's weekly facts and figures – 28 January 2012

Tuesday, January 31, 2012

Volatility

For the first time since before the US debt-ratings downgrade, market volatility returned to the average level of pre-GFC volatility. The ASX 200 posted another gain of just over one per cent for the week following a string of weekly gains for the year – totalling 5.7 per cent for the year-to-date.

Fear

Fear – or irrational volatility – stayed within the tramlines and finished the week right in the middle of the normal zone making the current run of 'normal' fear two months long. This result is a very encouraging sign of how the market may deal with future adverse shocks.

Disorder

Disorder – a measure of the lack of similarity in returns across sectors of the market – remained at low levels and finished the week just below the lower tramline. Controlled fear and disorder are, in our opinion, necessary conditions for a market to sustain a rally.

Capital gains forecasts

Our forecast for the next 12 months remained at just under 13 per cent. Given reporting season starts in a week or two, this is yet another encouraging result.

Market exuberance

The week closed with exuberance just over fair price at +0.3 per cent – for the first time since early April 2011. While underpricing has been eroded by the January rally, the combination of volatility, fear and disorder makes current market conditions by far the best since before the August – November chaos. The market is about 500 points below when the market was last at fair pricing. This situation has arisen because the fundamental level was eroded during the latter half of 2011. With capital gains forecasts strong at 13 per cent, the fundamentals are in a position to rise again with the market if it continues to rally.

Sectoral exuberance

Only IT, Health and Staples seem to be cheap. Telco is expensive and the rest are in a range of ±2 per cent. More detail is contained in our companion weekly publication Woodhall's ASX 200 Exuberance Stats.

Summary

The US market is a little overpriced so its soft finish to the week was a relief. US GDP at 2.8 per cent was a little below expectations. The fall in yields for European debt is most encouraging. 2012 is shaping up to be the best in a while.

All data are sourced from Thomson Reuters Datastream.

 

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

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Q3 market review

Thursday, October 06, 2011

Big picture

Being an investor in the third quarter felt like an old boxer after having gone a few rounds with Mike Tyson. The fall in the market brought back the horrors of 2008 and, just when things seemed to be getting a little better at the end of August, the market found a new low for the year.

The fundamentals are quite strong. It seems that the end of the world has been priced in. If the world doesn't end, there should be a sharp rally but that might not be for a few months yet. It depends on too many decisions to make an ‘educated’ guess at when we will bottom. There are signs that the market might not suffer any more significant declines but it might ‘bounce along the bottom’ for some time.

One of the big risks is that investors might miss the start of the next rally – being bruised by what has gone on. Investors in cash who wait for signs of life – like returning to the old 4800 to 5000 range – will miss out on the first 20 per cent leg up. For those who are prepared to go the distance, it might be just one more ‘war story’ to tell around the barbeque.

With dividends yield in double figures for the banks, including franking credits and deposit rates starting to fall, there do seem to be good opportunities in the financials sector. If we find out that China has been in total control of its economic destiny, there are massive returns to be had in some mining stocks just to get them back to where they were in April.

A lot to contemplate. A lot at stake.

Capital gains forecasts

We use broker forecasts of dividends and earnings to construct our forecasts of capital gains and total returns (that is, including dividends) for each major sector of the S&P/ASX 200 and the market.

We construct 12-month-ahead forecasts each day and show the capital gains forecasts in Chart 1 updated for each day for the last 12 months. Of course, each forecast period finishes 12 months after the forecast origin and so the moving nature of the target should be taken into account when analysing this chart.

It is common for broker forecasts to be updated more so during the February and August reporting seasons, when companies typically update their guidance, than at other times.

The August reporting season was solid but the accompanying outlook statements were tainted by the uncertainty caused by the global problems. Accordingly, capital growth forecasts came off by about four percentage points in August but stabilised during September at a little over 10 per cent for the next 12 months. Since average capital growth has been about seven per cent, this forecast is still reasonably optimistic despite the noise in the markets.

Market exuberance

Exuberance is an estimate of the degree of over or underpricing in the market or sector relative to our capital-gains forecasts. It is a medium term measure (of up to six to nine months) that we use to try and identify short-term bubbles and buying opportunities.

When exuberance is above the six per cent dotted line, we use it as a potential signal of an imminent six to 10 per cent correction, or an indication that the market may trade sideways until the fundamental has risen to erode any overpricing. It is not designed to be a trading tool. It is a guide for market entry and rebalancing.

The market continues to be underpriced – and by nearly as much as it was during the GFC before the big rally from early March 2009. I took the consensus broker forecasts of 'target price' for each company to produce what is, in effect, an alternative way to compute capital growth forecasts from the method I prefer. Interestingly, these forecasts produce an outcome consistent with our forecast plus our mispricing estimate – an aggregate of about 25 per cent for the next 12 months.

Most analysts and commentators seem to be saying that the market is oversold – pricing in Armageddon – so at some point there will be a strong rally. Given the lack of political leadership around the globe, it is difficult to even make a wild guess of when that rally may start. The problem with strong rallies is those who miss the start and wait for a pullback might end up missing out on some good returns. Buying now might prove to be very profitable but the market is not for the faint-hearted.


Sector exuberance

We calculate exuberance for each of eleven sectors of the ASX 200 and the aggregate separately. These measures are based on our sector and market capital gains forecasts. It is quite normal for some sectors to have estimates indicating they are overpriced while others are underpriced. Such lack of conformity can be used to aid rebalancing and market entry.

Relative mispricing can be used to stagger market entry by first buying those sectors which appear to be cheap. Similarly, when rebalancing a portfolio, it is possible to first sell in seemingly expensive sectors to generate the cash to buy later in cheaper sectors.

Although the market is very underpriced (by our measure) the mispricing is not uniform across sectors. Indeed, the telco sector is a little overpriced! Two defensive sectors, consumer staples and utilities, are only moderately underpriced.


Sector forecast returns

We believe that it is much easier to predict the returns of an aggregate, like a sector, than an individual company. We use certain statistical methods to ‘clean up’ the company data before it is aggregated into sectors and then the market as a whole.

We know that expected equity volatility is so large compared to expected returns that it would only be by chance that these forecasts turned out to be ‘accurate’. However, the relative sizes of these sectoral forecasts have historically contained very good information and these forecasts underpin our measures of sector exuberance.

The expected returns have changed markedly over the last quarter. Energy, materials and industrials are now more or less level-pegging with around 20 per cent growth expected – excluding dividends. The expected dividends from utilities are necessary to drag its total return forecast into positive territory. Little capital growth is expected in consumer discretionary, financials and property.

Sector volatility forecasts

Sector and market volatilities tend to come in clusters when notable events – such as the sovereign debt crisis – impact the market. Volatility then tends to revert to some mean level. Occasionally, however, the 'mean’ shifts to a new semi-permanent level.

Our forecasting method allows for both clusters and regime shifts. In this way, we hope to react more quickly to new information as it arrives.

At the end of January 2011, we called the end of the financial crisis in that the Financials sector expected volatility was at the low end of pre-GFC levels. Its volatility picked up a little in the first half of 2011 but the turmoil flowing from the European sovereign debt crisis and the political wrangling in the US over deficit reduction has taken all forecast volatilities much higher – with that for Financials now above 20 per cent.

Indeed, there has been a compression of the range for these sectoral forecasts with consequent implications for sectoral allocations.

Risk-adjusted sector returns

We combine our 12-month ahead excess total returns' forecasts over the risk-free rate with our three-month ahead (annualised) volatility forecasts in Chart 6. For this purpose, we are assuming that each sector grows at a constant rate throughout the year.

These risk-adjusted excess returns are often referred to as Sharpe ratios. They are used in our sectoral allocations but, of course, we also need to incorporate forecasts of the correlations between the sectors. The principles of diversification tell us that we should not focus on Sharpe ratios in isolation.

Interestingly, there are marked differences across sectors in these ratios. Only those for Energy and Industrials are reasonably strong. On its own, this part of the analysis would not encourage investment in the market – the market risk does not adequately reward the expected return over the risk free rate. But when this analysis is combined with the underpricing results, a strong case for being in the market could be made.

Sector allocation

We combine our sector forecasts of total returns, volatility and correlations between sector returns to form the basis of our sector allocations.

Because we are using three-month-ahead forecasts, these weights would be rebalanced or rotated each quarter. Given our philosophy, such rebalancing would be done in conjunction with sector exuberance.

We, like many others, put limits on how far our optimised sector weights can deviate by the ‘market cap’ weights that form the index.

The outcome is highly dependent upon how these ‘tilts’ are defined. They should reflect the risk tolerance and needs of the investor.

No investor should ever take these recommendations as the basis for forming a view. They do, however, allow investors to keep up with changes in risk, returns and correlations.

Since last quarter, there has been a big shift back to energy and materials and away from financials. Property gets a zero allocation.

Volatility regimes

In order to support the highly technical forecasting method we use to forecast sector volatility, we monitor market volatility on a daily basis.

We use the same concept of short-term volatility clusters and regime shifts for long-run (mean reverting) levels.

The daily estimates of volatility are described by the yellow line. The lower dotted line is the average long-run level for 1985-2003. The higher dotted level is the GFC level (July 2007-December 2009). The solid black line shows the extent of the post-GFC decline as it is the average post-GFC level (represented by the median).

It is clear from the chart that the US disruptions starting at the end of July, combined with the growing European problems, has taken volatility back up into the high range – but not as bad as it was during the height of the GFC.

Volatility started to return to normal after the US debt downgrade but Europe helped to re-ignite market volatility. It is stating the obvious to say that this isn't a good time to start getting back in the market for those sitting on cash. For those in the market, it might pay to wait and ride this one out – if you can take it.

Fear

Our measure of fear is based on a series created in early 2008 to help explain why exuberance measures were not behaving as normal.

The underlying principle is that markets usually go up or down from open to close depending on the sentiment of the day. When the market lurches from one direction to the other during the day, it is a sign of excess volatility, irrational volatility or fear.

We have found that this measure, and our equivalent measure for the US market, tends to lead the ‘VIX’ indexes for Australia and the US.

Importantly for our methodology, we acknowledge that fear exaggerates behaviour. When fear is high, overpriced markets can fall rapidly and underpriced markets can fall or stay down for longer periods of time.

The two dotted lines (or tram lines) in Chart 9 define the range that fear oscillated, pre-GFC, 66 per cent of the time.

Although fear in the US started to rise at the end of July, our measure for Australia did not kick up until the second Tuesday in August – when the market staged a seven per cent recovery from mid-day to finish up for the day to close at just over one per cent. Our market quickly settled – but the US did not. The levels of fear over September were heightened and were conducive to allowing a rally to start.

Disorder

Disorder measures the extent to which sectoral returns move together on a daily basis. In previous research, we found that increases (decreases) in disorder lead increases (decreases) in market volatility.

If the main ‘play’ is to buy the index, disorder would be very low. When the GFC was at its height, investors were almost panicking in switching sectors such that, at extremes, one sector rose more than five per cent on the same day that another fell by more than five per cent.

The disorder tramlines contained 66 per cent of the observations pre-GFC and so give guidance about what is normal.

After a year in the very low range, disorder has twice burst through the top tramline in August and September. Much of this disharmony can be attributed to the two assumptions (or is it conclusions?) that China will slow down and banks will be affected by the sovereign debt crisis. Our proposition throughout the whole of the GFC was that the market is unlikely to take off when both fear and disorder were above the tramlines. Conditions can change quickly but the end of September was not conducive to confident investing.

 

The Woodhall Way

We, at Woodhall, have defined a systematic way of analysing the market and taking a position. We also are able to monitor the market on a daily basis. Being systematic does not make anyone right! Indeed, on any given day, the most silly, ill-founded forecast could prove to be the best after the event. We believe that we have more chance of making good decisions if we understand how we made them and, importantly, can learn from mistakes because we can work out what it would have taken to be right!

We do not take any forecast or measure literally – as a certainty. Rather we look at all the statistics in this report and try to work out a common story that links all the analysis. Anyone can cherry-pick and selectively take a position. We also believe that signals sometimes collide and no reasonable forecast can be made. In our opinion, total reliance on formulae (ie a real Quant) is destined for failure. Being able to mesh scientific process with expert opinion has more chance of survival than gut feelings.

The way we read the results in this research note is:

  1. Reporting season was 'good enough' in August but the accompanying outlook statements were subdued through lack of information about the possible impact of Greece and the US.
  2. Our broker-based forecasts were downgraded by about four per cent during August but expectations for the next 12 months are moderate at 10 per cent for capital growth.
  3. The resource-based sectors of energy, materials and industrials – particularly mining services – are back in favour after they took a hammering in Q3.
  4. Fear and disorder have both been high in recent times. We argue these statistics have to be in the moderate range before a rally can commence.

We will monitor our analysis on a daily basis in case the situation changes (it usually does).

The risks

There are always so many possible risks that they are too numerous to mention. At Woodhall we feel the need to have a solid base but we are totally aware that ‘stuff’ happens.

Ignoring the unknown unknowns, some risks were and are on the cards:

  1. The US is failing to come up with a viable deficit reduction/stimulus set of policies. With the election over a year away, it may be some time before markets settle.
  2. Despite talk of a double dip recession in the US – which must be possible – the recent US economic data paints a picture of sluggish growth rather than recession.
  3. The Europeans are taking a long time to sort out their problems with Greece. All 17 member nations have to agree before resolution. Many countries are experiencing political backlashes from their voters – particularly in Germany.
  4. China could suffer a hard landing. The data so far suggest otherwise but in these times, there are plenty of people thinking the worst.
  5. Commodity prices are well off their peaks following a rapid tumble – but iron ore is holding up. Further falls would hurt Australian mining. The jury has to be out on this one – no one can predict commodity prices well in the short run.
  6. Oil and our dollar fell sharply at the end of the quarter. These falls will help the lower speed part of our economy but the dollar could bounce back if the 'mood' returns to China and commodities
  7. Will the RBA raise rates? There are people in both camps. A rate rise will help to appreciate the dollar while a fall may stimulate consumer confidence and help our dollar to return to traditional levels.
  8. The things we didn’t think of!

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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It's still the dollar!

Thursday, August 18, 2011

The ASX 200 has traded sideways for 18 months while the S&P 500 boomed and bust.

Our argument that we put forward in a January 2011 edition of Money Management and again on SWITZER on 2 March still holds. We are moving in lock-step with the US when we price both in the same currency! This strong relationship helps partly explain some of the movements in last week's market turmoil.

With the chance of a statement from the RBA of rates not going up – or even a little rate cut – could take our dollar firmly below parity.

When the markets recover, we might start to gain ground on the US.

This argument has nothing to do with two-speed, or patchwork, economies. It is a valuation problem. Foreigners view our market in their own currency.

The dollar

Since the start of 2010, our dollar against the US greenback has traded in a near 40 per cent range – see Chart 1. There is little disagreement – if any – that these movements are due to commodity prices and the expected interest rate differential between Australia and the US.

Importantly, it is the expectations – and not just the differential – that counts. The Reserve Bank of Australia (RBA) has run at least an implicit campaign that rates will rise this year since the last increase on Melbourne Cup Day 2010. This expectation arguably drove rates up through parity and as high as more than 110 US cents.

Chart 1: The Australian dollar

Source: Thomson Reuters Datastream

Even in July 2011, the consensus was for a rate rise or more. Westpac announced a forecast of a one per cent cut within a little more than a year. We wrote in Ron's Wrap 1 August on our website that this forecast was a bit over the top. A little 25bps cut would do the trick – even saying no rate rise would be a massive boost to confidence. Imagine you had just bought a house at, say, a variable rate of eight per cent and someone keeps telling you he is going to force rates up. Do you spend? Of course not, and we wonder why confidence and retail are struggling?

If the RBA said they were holding at 4.75 per cent, the differential wouldn't change, confidence would be up and the dollar would fall. Don't they get that?

The markets

Everyone knows the story that our market has range traded since at least January 2010. To compare our market with that in the US, I have rescaled the US data to start the period at the same point. They are only indexes – we can multiply by any number we want to so-call re-base them. I show them both on the same scale in Chart 2. S&P USD is the S&P 500 in US dollars rescaled to line up with the S&P/ASX 200 in Australian dollars – ASXAUD.

The story is clear and well known. They went up and fell; we went sideways and fell. Not fair. However, we are comparing apples and oranges. The ASX 200 is measured in Australian dollars. If we consider a fully-hedged position from the US, we need to convert Chart 2 to a common currency. Chart 3 is how a foreigner would see the problem. What is all the fuss – they are moving together – and in the same way we said more than six months ago! It is the same chart updated.

I can see a divergence around April - June 2010 when the mining tax debate drove our market down – we can now see the cost of that debate. Otherwise blow-for-blow – almost – the markets move in synch. Indeed, the massive volatility in markets for the week of 8-12 August didn't always get translated directly. We argued elsewhere on our website that the rapid fall in the Aussie cushioned our fall on two big days.

So where from here? If the RBA comes clean and our dollar starts to depreciate, we can start gaining ground on our own and against the US. We have our market underpriced by 15 per cent. Cheap markets can get cheaper – but this market is OK for me. We even have room for a five per cent catch-up against the S&P 500 on the dollar alone as at Saturday 13 August!

The two-speed economy impact would have some sectors - like retail and tourism - hurting but not others. The correspondence wouldn't be as close if that were the problem. Of course the dollar is hurting some businesses - but we will see that in the earnings in due course. What we see in Charts 2 and 3 is a day-by-day revaluation.

Chart 2: A comparison of the Australian and US markets in own currencies

Source: Thomson Reuters Datastream

Chart 3: A comparison of the Australian and US markets in same currency

Source: Thomson Reuters Datastream

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Wall Street connection, No. 1, 2011

Friday, July 15, 2011

Key points

We have applied the investment methodology that we developed for the ASX 200 to the US market and found that, without any adjustments, the same technology seems to work equally well in both markets.

Our forecast for capital growth on the S&P 500 is about 13 per cent for 2010/11 which is a little lower than the near 15 per cent we have for the ASX 200.

Our market is about six per cent underpriced at the time of writing while the S&P 500 is a little overpriced.

The experiment

In this first issue of 'Wall Street connection', I describe how we have transported the IP we developed for the ASX 200 to the S&P 500. The idea of this series of papers is to produce occasional issues when the results of the analysis warrant it.

Most would agree that our market is influenced by movements in the S&P 500 but that the relationship changes over time. Our insights are designed to add colour and substance to this evolving relationship.

Our investment methodology at Woodhall has broker forecasts of dividends and earnings at the centrepiece of our analysis of the ASX 200. We take the Thomson Reuters Datastream consensus forecasts of earnings and dividends and turn these into our own forecasts of total returns (including dividends) and capital gains for the ASX 200 and its 11 major sectors for the next 12 months – which we usually updated each month. We combine these total return forecasts with our highly technical method of forecasting volatility for the same sectors to produce optimised portfolio sector weights. We use these capital gains forecasts with the sector and broader index price series to produce an estimate of under- or overpricing – which we call exuberance.

In a separate line of inquiry, we developed other measures of volatility – which we refer to as our fear index, disorder index and cross-sectional volatility index. We use these measures to gain additional insights into market behaviour to the extent that we believe the concepts these statistics measure interact with market direction and market-timing opportunities. However, I will focus on returns forecasts and exuberance in this issue.

We have applied this same methodology to the S&P 500 from the same data source. Obviously there are many more companies in the S&P 500 and that should benefit our averaging techniques. The S&P 500 does not appear to disaggregate Financials into Financials-x-REITS and REITS (or Property) as does the ASX 200 and which we use in our Quant Quarterly publication.

There are two fundamental differences between the two markets. First, the sector weights are very different across markets and, second, the nature of the companies within the sectors are, in many cases, markedly different. I show the sector weights in Charts 1 and 2. The IT sector is the largest in the S&P 500 and tiny by comparison in the S&P 200. The converse is true for Materials. Financials, including REITS, has more than double the comparable weight in the ASX 200.


Not only are the relative weights different but so are the component companies. Health in the S&P 500 includes many some global pharmaceutical companies but the ASX 200 counterpart is very much dominated by one company, CSL, which is widely known for its blood plasma. IT in the S&P 500 includes major manufacturing companies but the dominant player in the ASX 200, Computershare, is a major share registry company.

Returns' forecasts

I show the forecasts for the S&P 500 and its 10 major sectors in Chart 3 as at 30 June 2011. The expected capital gains for the broader index imply a reading of 1400 for the end of 2011 (assuming a constant growth rate over the financial year). Just before the year-end – when the index was below 1300, Goldman Sachs (Jim O'Neill) and Barclays (Barry Knapp) reiterated their common forecasts of 1450 for the year-end (Bloomberg TV). Given that these forecasters are highly respected, our interpretation of broker forecasts can be considered reasonably conservative – particularly since one third of that incremental forecast gain was made in the first week of 2011/12. The total return forecast for Financials jumped from 25 per cent to 34 per cent a week after these forecasts were constructed.

If I compare these forecasts with those in our Quant Quarterly for the same period, the ASX 200 capital gains' forecast is a little stronger at 14.5 per cent. Given the links between the two markets and our current lag behind their recent gains, I feel that our Australian forecast has gained more credibility from our US comparison.

Mispricing

On a recent appearance on Switzer TV and the July 2011 issue of Professional Planner, I showed that our measure of exuberance for the US showed the same basic characteristic as that for the ASX 200. That is, when overpricing reached six per cent, the market often retreated into a correction – or traded sideways for an extended period. Of course, I do not believe in any exact response to the 'magic six per cent' line but it does make me ratchet up my risk management procedures when it gets nudged!

I show an updated version of the US measure (to the close on 7 July 2011) in Chart 4. Our philosophy includes the notion that markets are irrational – at least a little – so that sentiment pushes and pulls the market out of line with fair pricing. Of course, no one knows what fair pricing is. The sentiment swings are how the market works out – sadly after the event – approximately where fair pricing was.

Investors bid up – or down – market prices until it becomes 'so obvious' that the market is mispriced, the direction of price discovery reverses. Cheap markets can get cheaper, particularly if the level of fear (using our fear index) is high, and disorder (another of our indexes) is also high. On the flip side, the market rarely seems to get much more than six per cent overpriced – but it usually falls more quickly when fear and disorder are high when the correction begins. It so happens that the mid-February correction occurred just after exuberance hit the six per cent dotted line.

A coincidence? Possibly. Data were not readily available to go back further to best test this hypothesis. Our ASX 200 estimates go back to 2002. However, I have included 10 charts, one for each sector of the S&P 500, at the end of this article in an Appendix. I find the patterns startling. Perhaps you will too? I now feel confident that the same technology works as well for the S&P 500 and its components as for the ASX 200. 

What I believe happened in February is that the S&P 500 was overheated and so corrected – bringing the ASX 200 down with it – even though the latter was not mispriced at the time. Around 30 June 2011, the S&P 500 reversed its underpricing and is now a 'little warm' being about two per cent overpriced (as at 7 July 2011). At the same point in time, we estimate that the ASX 200 was more than six per cent underpriced. The problem for our market is now how it gets back to fair pricing without the S&P 500 again getting hot and correcting. Elsewhere I have expressed my view that catch-up might require a fall in our dollar. We express no view on short-term fluctuations of the dollar.

The same mispricing can be shown in a three-dimensional 'heat map' chart of the S&P 500 – in Chart 5 – use a sequence of dots rather than a line. I use different coloured dots to show different degrees of mispricing. In the big QE 2 (loose monetary policy in the US) run from October 2010 to February 2011, the colours changed – but slowly – because the forecasts at the time were stronger than they are now. The single red dot in February 2011 marks the turning point and six per cent overpricing. Importantly, the US market is now higher – but by only a handful of points – yet the latest dot is only black for 'warm'. Elsewhere I have written that I think of our changes in our colour coding as marking evolving resistance levels.

So for those who choose to read our research, the modification to our philosophy is as follows. We still think of ASX 200 exuberance as a tool that might be used in judging market mispricing. We still think a correction of six to 10 per cent is more likely after the magic six per cent line is breached – or that there might be sideways movement of the market for an extended period. However, we now add to our armoury that a correction is also possible if our market is not overpriced but the US market breaches its six per cent line. Our market could then correct with the US.

Again, using the dashboard analogy to understand how we use our 'dials', consider the following proposition. If you were driving in your car in the city and you found yourself overtaking everyone else and the other drivers were honking their horns and gesticulating at you, would you:

a) Keep going at the same speed and wave back?

b) Assume your speedometer was broken and slow down with the traffic or stop and call a road service?

c) Assume your speedometer was correct but road conditions had changed – so slow down anyway until you get more information?

Clearly the answer is not a). Answers b) and c) seem like reasonable responses to me. Although we know this situation can happen, we typically do not dismantle our speedometer because sometimes it may not produce the information we need. We keep it and add judgement (and maybe get the speedo fixed). In the same way, we think of exuberance like the speedometer in the question – it needs to be used with a modicum of common sense. It is not a strict trading rule. We have tried to find one but without success. Take, for example, late 2009 on the ASX 200. Exuberance was over six per cent for months without a correction – it just traded sideways for about a year. Sometimes markets do not correct – they wait for the fair price to catch up with the market level!

Takeaways:

The takeaways from this analysis for investors constructing and monitoring their own portfolios are:

  1. The US market appears to behave similarly to the Australian market so we can transport our methodology and measures to the S&P 500.
  2. We expect the S&P 500 price index to grow by about 13 per cent over 2010/11 but, of course, be subject to volatility and mispricing during and at the end of the year.
  3. The S&P 500 was heading to be moderately overpriced at the time of writing.
  4. The difficulty with our market is that we measure it to be about six per cent underpriced. Therefore, if our market moves up with the US in lockstep, the S&P 500 might get to correct again before the ASX 200 is even fair-priced.

Appendix: Sector exuberance on the S&P 500.

In all cases, the charts end on 7 July 2011.

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Quant quarterly – trends and forecasts

Wednesday, July 06, 2011

Big picture

Again we got ever so close to the 5000 barrier on the ASX 200 (4971 on 11 April) but the US being warned by S&P about their debt ceiling and the Australian dollar put paid to that rally. After reaching a low of 4451 on 20 June (a technical correction), a welcome rally picked us up to close only 230 points down on the quarter.

Technical analysts galore were saying that if we breached 4477 then lower we would go. But we bounced straight back. While we and the US did end the financial year on a reasonably strong rally, most of the problems suppressing our markets haven't gone away. Sure the Greek debt problem got a disguised default/bailout – which the ratings' agencies might still call an official default – but the Middle East / North Africa woes continue (but are largely off the front pages). The debt ceiling deliberations in the US is going down to the wire, our dollar is depressingly high and our non-resource sector faces gale force headwinds – not least of which in retail sales.

But if we take a dispassionate view of the data, things don't seem so bad. We finished the financial year up about 11 per cent including dividends – bang on the average for two years in a row. The market is heavily underpriced and broker forecasts are still optimistic about the future – capital gains of 14.5 per cent for 2011/12. Volatility, fear and disorder are well contained. All we are short of is a bunch of investors who don't think the world is going to end.

Given what we have been through in recent times, any strong rally is likely to bring profit takers out to force a pause in the market. Although many have been waiting for profit downgrades before the August reporting season, they haven't eventuated yet. If we get through reporting season reasonably unscathed, we could end up starting Q4 in a healthy position. Will we breach 5000 in Q3? We should, but recent experience suggests investors will run for cover before that happens. If the market can hang around just below 5000 for a month or two then the breakthrough makes sense.

Capital gains forecasts

We use broker forecasts of dividends and earnings to construct our forecasts of capital gains and total returns (that is, including dividends) for each major sector of the S&P/ASX 200 and the market.

We construct 12-month-ahead forecasts each day and show the capital gains forecasts in Chart 1 updated for each day for the last 12 months. Of course, each forecast period finishes 12 months after the forecast origin and so the moving nature of the target should be taken into account when analysing this chart.

It is common for broker forecasts to be updated more so during the February and August reporting seasons, when companies typically update their guidance, than at other times.

Capital gains' forecasts slipped a little during Q2 with another one per cent off on the last day of June. At these levels, our conclusion is that earnings' forecasts are strong but many expected downgrades to be signaled by companies before the season opens. If that is the case, then our forecasts will also be revised down.

Market exuberance

Exuberance is an estimate of the degree of over or underpricing in the market or sector relative to our capital-gains forecasts. It is a medium-term measure (of up to six to nine months) that we use to try and identify short-term bubbles and buying opportunities.

When exuberance is above the six per cent dotted line, we use it as a potential signal of an imminent six to 10 per cent correction, or an indication that the market may trade sideways until the fundamental has risen to erode any overpricing. It is not designed to be a trading tool. It is a guide for market entry and rebalancing.

Underpricing continued to build up during Q2. Of course, the usual suspects of mining taxes, carbon taxes, and the dollar contributed but, now that we analyse US data in the same way that we analyse the ASX 200 in this quarterly, we know that the S&P 500 bounced off the 'magic ' six per cent barrier of overpricing – bringing our market down with it.

The S&P 500 finished the quarter only mildly underpriced but our market continues to display good value for investors. Our market could reach 5000 quickly and only be a couple of percent overpriced. As we will see at the end of this report, fear did rise sufficiently over the Greek bailout deliberations in their parliament that a rapid rise is less likely than a steady gain. But good news in August could soothe our wounds.

Sector exuberance

We calculate exuberance for each of eleven sectors of the ASX 200 and the aggregate separately. These measures are based on our sector and market capital gains forecasts. It is quite normal for some sectors to be estimated to be overpriced while others are underpriced. Such lack of conformity can be used to aid rebalancing and market entry.

Relative mispricing can be used to stagger market entry by first buying those sectors which appear to be cheap. Similarly, when rebalancing a portfolio, it is possible to first sell in seemingly expensive sectors to generate the cash to buy later in cheaper sectors.

While property, telco and utilities were more or less fairly priced at the end of Q2, the same could not be said for the other sectors. In particular, energy, materials and industrials had been really oversold – possibly on fears that China was slowing too quickly. China does not seem to be in trouble so a bounce back in these sectors is quite possible.

Consumer discretionary, on the other hand, is also underpriced by about 10 per cent but this case could be very different. There are strong arguments that internet shopping, the high dollar and the newfound shopper resistance to high retail margins could force a new profit paradigm on this sector. As such, broking analysts may not yet be in a position to identify the new trend and so their forecasts for this sector could be overly optimistic.

Sector forecast returns

We believe that it is much easier to predict the returns of an aggregate, like a sector, than an individual company. We use certain statistical methods to ‘clean up' the company data before it is aggregated into sectors and then the market as a whole.

We know that expected equity volatility is so large compared to expected returns that it would only be by chance that these forecasts turned out to be ‘accurate’. However, the relative sizes of these sectoral forecasts have historically contained very good information and these forecasts underpin our measures of sector exuberance.

Energy and materials remain the standout sectors for capital growth and total returns. Materials forecasts are strong but well below those for energy and industrials.

Dividends forecasts for the financials sector underpin otherwise relatively weak total returns forecasts. The same could be said for property but most of the other sectors – other than consumer discretionary – look solid.

Sector volatility forecasts

Sector and market volatilities tend to come in clusters when notable events – such as the sovereign debt crisis – impact the market. Volatility then tends to revert to some mean level. Occasionally, however, the 'mean’ shifts to a new semi-permanent level.

Our forecasting method allows for both clusters and regime shifts. In this way, we hope to react more quickly to new information as it arrives.

At the end of January 2011, we called the end of the financial crisis in that the financials sector expected volatility was at the low end of pre-GFC levels. Its volatility has picked up a little since then but nothing to really worry about.

With the exception of the IT sector. there has not been much change in sector forecasts of volatility over the quarter. At these levels, sector volatilities are only a little above historical averages and so should not cause any great concern.

However, the relatively low industrials volatility to that for energy and materials makes the industrials growth forecasts in Chart 4 stand out. Our take on this sector is that it is the mining services part of this sector that is the engine for stable expected growth.

Risk-adjusted sector returns

We combine our 12-month ahead total returns' forecasts with our three-month ahead (annualised) volatility forecasts in Chart 6. For this purpose, we are assuming that each sector grows at a constant rate throughout the year.

These risk-adjusted returns are often referred to as Sharpe ratios. They are used in our sectoral allocations but, of course, we also need to incorporate forecasts of the correlations between the sectors. The principles of diversification tell us that we should not focus on Sharpe ratios in isolation.

The market remains strong with a Sharpe ratio of 1.5 but Industrials is a real standout at over three. Energy, staples and utilities are strong but even property and IT are not overly weak. The strength in utilities has largely come from reduced expected volatility rather than increase in expected returns over the quarter.

Sector allocation

We combine our sector forecasts of total returns, volatility and correlations between sector returns to form the basis of our sector allocations.

Because we are using three-month-ahead forecasts, these weights would be rebalanced or rotated each quarter. Given our philosophy, such rebalancing would be done in conjunction with sector exuberance.

We, like many others, put limits on how far our optimised sector weights can deviate by the ‘market cap’ weights that form the index.

The outcome is highly dependent upon how these ‘tilts’ are defined. They should reflect the risk tolerance and needs of the investor.

No investor should ever take these recommendations as the basis for forming a view. They do, however, allow investors to keep up with changes in risk, returns and correlations.

The position in financials has slipped a little from last quarter. Materials remains stuck on the low-side tilt we place on the allocation weights. Property has jumped up from the lower bound last quarter to above market weight this quarter. Much of the reduction in the financials weight over the quarter has gone to property.

Volatility regimes

In order to support the highly technical forecasting method we use to forecast sector volatility, we monitor market volatility on a daily basis.

We use the same concept of short-term volatility clusters and regime shifts for long-run (mean reverting) levels.

The daily estimates of volatility are described by the yellow line. The lower dotted line is the average long-run level for 1985-2003. The higher dotted level is the GFC level (July 2007 to December 2009). The solid black line shows the extent of the post-GFC decline as it is the average post-GFC level (represented by the median).

The post-GFC regime has almost got back to pre-GFC levels. Given the major events that continue to bombard the world economy, it is surprising that volatility did not kick up more. It is doubtful that the Greek debt issues have gone away for long but if new surprises stay away on that front, we expect that volatility will not be as much as a problem in Q3 as it was in Q2.

Fear

Our measure of fear is based on a series created in early 2008 to help explain why exuberance measures were not behaving as normal.

The underlying principle is that markets usually go up or down from open to close depending on the sentiment of the day. When the market lurches from one direction to the other during the day, it is a sign of excess volatility, irrational volatility or fear.

We have found that this measure, and our equivalent measure for the US market, tend to lead the ‘VIX’ indexes for Australia and the US.

Importantly for our methodology, we acknowledge that fear exaggerates behaviour. When fear is high, overpriced markets can fall rapidly and underpriced markets can fall or stay down for longer periods of time.

The two dotted lines (or tram lines) in Chart 9 define the range that fear oscillated, pre-GFC, 66 per cent of the time.

The fear associated with sorting out the Greek Debt and US deficit ceilings in June has only been surpassed by that caused the Japan nuclear disaster. But fear receded quickly yet again. There was enough fear to make 'cheap markets cheaper' in June but without new shocks, underpricing can be eroded reasonably quickly.

Disorder

Disorder measures the extent to which sectoral returns move together on a daily basis. In previous research, we found that increases (decreases) in disorder lead increases (decreases) in market volatility.

If the main ‘play’ is to buy the index, disorder would be very low. When the GFC was at its height, investors were almost panicking in switching sectors such that, at extremes, one sector rose more than five per cent on the same day that another fell by more than five per cent.

The disorder tramlines contained 66 per cent of the observations pre-GFC and so give guidance about what is normal.

Until the last few days of Q2, disorder remained amazingly low. It seems that index plays continue to dominate the market. No particular sector seems to have caused the recent uptick in disorder – and it is still well below the upper tramline. No cause for concern here.

The Woodhall Way

We, at Woodhall, have defined a systematic way of analysing the market and taking a position. We also are able to monitor the market on a daily basis. Being systematic does not make anyone right! Indeed, on any given day, the most silly, ill-founded forecast could prove to be the best after the event. We believe that we have more chance of making good decisions if we understand how we made them and, importantly, can learn from mistakes because we can work out what it would have taken to be right!

We do not take any forecast or measure literally – as a certainty. Rather we look at all the statistics in this report and try to work out a common story that links all the analysis. Anyone can cherry-pick and selectively take a position. We also believe that signals sometimes collide and no reasonable forecast can be made. In our opinion, total reliance on formulae (that is, a real Quant) is destined for failure. Being able to mesh scientific process with expert opinion has more chance of survival than gut feelings.

The way we read the results in this research note is:

  1. The market took the major events of the quarter without excessive volatility. Disorder is low and fear has returned to low levels after the Greek bailout vote in the Greek parliament. Volatility is normal. Since stability has just returned to the market, it may be a couple of weeks before we see some market action – particularly with the August reporting season just around the corner.
  2. Broker forecasts were downgraded a little during 2011:Q1 but expectations for 2011/12 remain strong at 14.5 per cent for capital growth.
  3. Industrials – particularly mining services – look the strongest sector.
  4. Diversification is, as always, very important. The financials sector has been marked down during the quarter with much of its weight being transferred to property.
  5. We will monitor our analysis on a daily basis in case the situation changes (it usually does).

The risks

There are always so many possible risks that they are too numerous to mention. At Woodhall, we feel the need to have a solid base but we are totally aware that ‘stuff’ happens. We revisit last the risks we called last quarter and move forward.

Ignoring the unknown unknowns, some risks were and are on the cards.

  1. The US growth story is still there but it is not as strong as it was. The Federal Reserve expects growth to pick up a little in the second half of 2011.
  2. QE2 has ended but the Fed is playing backstop if it is needed. The big question is whether economic growth will continue without further easing.
  3. Despite the odd pessimist or two, China seems to be containing its inflation and growing.
  4. The ratings' agencies might classify the Greek bailout as a credit default. If it does, there is likely to be some increased market volatility.
  5. The Australian Labour party is still far from in control. What does a Carbon Tax do if people are compensated for its cost? The political situation cannot be helping our market.
  6. Will there be write-downs before the August reporting season? Some are inevitable but how bad? 
  7. Oil has been all over the place – a $23 dollar range. The US is willing to intervene in this pre-election build-up.
  8. How will the deficit ceiling issue be resolved in the US? A default is surely out of the question – and how long will Geithner stay? More instability abroad.
  9. Will the RBA raise rates? Surely not this quarter.
  10. The things we didn’t think of!

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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