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Woodhall's Wall Street Connections

Ron Bewley
Wednesday, May 02, 2012

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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.

Published: Wednesday, May 02, 2012


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