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Woodhall's March Wall Street Connections

Ron Bewley
Friday, March 02, 2012

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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.

Published: Friday, March 02, 2012


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