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Woodhall's April Wall Street Connections

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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.

Published: Wednesday, April 04, 2012

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