After Ukraine: Market poised to break 2014 trading pattern

Just as the market seemed directionless, the dreadful events in the Ukraine today (July 18) have sent a shudder through global equities. The news of the shooting down of a civilian jet on the Russia- Ukraine border, possibly by pro-Russian forces, immediately sent Wall Street (which only got the news late in the session) lower by 1%; European markets fell harder.

On the ASX an early sell-off saw stocks fall by 0.5%. Meanwhile, across international markets this worrying incident is certain to prompt some selling as tensions escalate between Russia and the United States.

Moreover, the timing is deeply interesting from a market technical perspective for the simple reason that our markets – the ASX in particular – have been trading in a relatively narrow band for the last six months.

The ASX had been testing the top of its trading range mid-week after closing on Thursday, on the eve of the Ukraine tragedy, at 5,522.

Until this week local analysts had regarded the upcoming full-year reporting season for the 12 months to June 30, which begins mid-August, as the key test facing equity markets. The earnings season must now be balanced with geopolitical developments including increasing tensions in the Middle East and the specific impact of the loss of Flight MH317, which will disturb prices in everything from gold to oil to airline stocks.

As you will see from the charts below, our markets have been literally poised for a breakout – what has been missing is a trigger or catalyst event that would encourage traders to break from the range.

Since February this year our market has been swinging within a range of 5,350 and 5,520. Whenever the All Ordinaries index breaches 5,500 it falls back, and whenever it falls below 5,400 it bounces back.

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If one makes a wider band then it’s been ranging sideways for five months, as can be seen below.

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The trendless nature of the market is confirmed by the KST short and longer-term weekly indicators, which have embraced each other at close to zero momentum for four months and which is abnormal.

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Trendless markets are prone to whipsaws for trend-traders. For instance, an 80 day moving average trend-line for the All Ords index is normally a good way of timing its medium term waves, but in the current trendless market it would generates too many losses from whipsaws. Hence it makes more sense to stay on a buy signal unless this market falls below 5,300.

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More aggressive traders think the way to exploit this market is to sell whenever the All Ords index exceeds 5,500 and buy whenever the index falls below 5,400. The problem with this tactic is that no one knows whether the market will continue to swing sideways or break out of its recent range by soaring north or plunging south. See next chart.

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So if you are nervous about this market wait for a break below 5,300 before selling since the market is presently relaxed and comfortable, judging by the Australian VIX volatility index (colloquially called the Fear index), which is at a record low just like its American cousin. A low VIX is associated with a bull market, which is why it makes more sense at this stage to hold shares than sell them.

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The burning question is whether the US share index will fall back to the World share index or whether the World (and Australia) will catch up to the USA?

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The bull (optimistic) case is:

1. America’s sharemarket rise has been underpinned by a rise in corporate profits, so there is no reason for it to crash.
2. Though the Federal Reserve is winding back its quantitative easing (a fancy name for money printing) the huge mountain of spare US dollars built up is not about to contract.
3. The digital revolution offers new markets and productivity improvements that will usher in a new era of growth not seen since the advent of the industrial revolution.
4. Cheap fuel (thanks to shale oil and gas), flexible hiring practices (reinforced by globalisation), cheap credit (thanks to central banks), new technology (e.g. 3-D printing) and a weaker US dollar are bringing manufacturing back to America.
5. American banks have been recapitalised, US households are deleveraging and the US government is paring back its deficit, which is restoring confidence.

The bear (pessimistic) case is:

1. Wall Street is trading at a valuation of 18 times reported earnings, the highest since 2011 when it underwent a 19% correction. Incidentally, the S&P/ASX 200 index is also trading at this elevated level, suggesting it too is due for a pullback. The long-term price to earnings (P/E) multiple for both the US and Australian stock markets is around 14 to 15.
2. The US and rest of the world is still weighed down by excessive debt, so a return to normal interest rates (as being mooted by the Federal Reserve) would end the cheap credit that has fuelled the share boom since 2009.
3. Households are saving more and spending less so as to pay down debt. Governments are tightening their belts to cut their deficits. Banks are lending to big not small businesses. Also productive capacity exceeds sales in most countries. The end result is subdued economic growth, which is not conducive to a continued bull market.
4. China is restructuring its economy from being infrastructure and export driven to being consumer, environment and welfare focused. This should eventually lift the quality of life, but in the meantime is disrupting heavy industry and property development, which is retarding demand for imports. 
5. Most conventional assets (cash, bonds, shares, property) are offering low returns, forcing investors to take greater risks, which is stoking an asset price bubble that will burst with worsening warfare, government austerity and political gridlock around the globe.

As for Australia, we are struggling with the end of a mining construction boom, an overvalued exchange rate and a stalemate on repairing the federal budget. But working in our favour is a resurgence of housing construction, increased non-mining infrastructure spending (being funded from privatisation of utilities) and a reputation for being a safe haven.

Predicting how the world (and in turn markets) will pan out is impossible since there are too many unknowns, the cause/effect relationships are complex and shocks can be highly disruptive.

For example, who at the start of this year foresaw that an offshoot of Al Qaeda would capture a third of Iraq, that Russia would annexe part of Ukraine, sending shockwaves through Europe, that China’s territorial claims in the sea bordering Vietnam and the Philippines would be enforced, and that the killing of Israeli and then Palestinian youth would escalate into war? And 2014 is only half over!

Rather than forecast the market, I prefer to let the market tell me what direction it is taking and then respect that trend if it is up and reject it if it is down.

At present the Australian market can’t make up its mind, so it is drifting sideways. But history tells us that these periods of indecision end with a break out strongly upwards or downwards. When that happens I will rely on my trend-following strategies to tell me what to do. Such market timing is prudent risk management.

Percy Allan is a director of MarketTiming.com.au For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds, see www.markettiming.com.au.