All eyes on October to set next year's trends

Is the Australian sharemarket in the nascent stages of a new era where it will outperform its big brother in the US?

Is the Australian sharemarket in the nascent stages of a new era where it will outperform its big brother in the US?

Since October 2009 the S&P 500 index in the US has done a stunning 35 per cent better than the local bourse. This trend, though, seems to be reversing with the S&P/ASX200 index managing to fight back and record a healthy 5 per cent outperformance in the past three months.

For many, this is hardly long enough or significant enough to make any bold claims but it is certainly worth investigating what is happening.

The reasons behind the multi-year underperformance by the Australian sharemarket are debatable. At the top of the list would be a strong Australian dollar, massive monetary stimulus in the US and a declining mining market due to the slowing Chinese economy.

As has been well documented, the US has slashed interest rates and spent trillions on bond purchases in a bid to inject liquidity and fire its domestic economic.

In the meantime, Australian interest rates have drifted down, but remain relatively high. This has been a big influence on the Australian dollar staying at or above parity to the US dollar, which is well above the long-term average.

This dynamic has led many local investors to hide in cash while US investors have been forced to go searching for some kind of return, with equities the big winner.

In addition, US investors who entered the Australian market in October 2009 have enjoyed a much more satisfactory return with a 15 per cent uplift on the currency trade.

So why is it feasible that we are on the cusp of reversing this trend?

To my mind, the pivotal change to the equation has been the decisive move by the Reserve Bank of Australia to loosen monetary policy by cutting official interest rates.

The 25-basis point reduction at the start of this month and the accompanying commentary got the equity market humming. Lower interest rates have a powerful impact on shares because it forces people out of cash holdings, allows analysts to increase their company valuations and generates hopes of an economic pick-up 12 to 18 months down the track.

Investors are now thinking the Reserve Bank will cut several more times in the coming six months, causing money to flow into a beaten-up sharemarket and gradually depreciating the Australian dollar.

The catalyst for this thinking has been dramatic tempering of the mining boom, allowing for supporting monetary action.

Perversely, Australian investors should be cheering for more bad economic news. The solid job numbers from last week might be music to some ears but not what sharemarket players want to hear. Instead, soft economic figures guarantee further cuts to official interest rates, which in turn stokes the fires for a protracted sharemarket rally.

Sharemarket investors will also hope that prices for key commodities such as iron ore and coking coal will remain soft and not bounce back to previous highs.

Nothing is guaranteed. We cannot forget the Federal Reserve in the US has begun an unprecedented bond-buying exercise that will flood the world with US dollars. In other words, it will be extremely difficult to devalue the Australian dollar.

Additionally, October is an ominous month for the market especially in the US. Contrary to what most of us think, October is not a rotten month for stocks and ranks second in performance over the last 20 years.

That said, October is critical because it has the uncanny knack of being the month when the market changes direction. We all know the great crashes of 1929 and 1987 took place in October but what is less well know is that October 2007 was the peak before the global financial crisis. October also marked the bottom for the bear market of 1982 and the tech wreck of 2002.

This all suggests we should tread wearily over the coming few weeks. If the US market was to change direction again this month, it could only head down given a 3?-year drive higher that has seen the main indices post gains of about 110 per cent.

Reasons why the markets would head south right now? The US presidential election, the unresolvable debt problems in Europe, paltry economic growth, sickly third-quarter earnings growth and the US fiscal cliff. For the tech heads, all of the major indices are within a mini-spurt of levels that proved too demanding in the previous rallies in 2000 and 2007.

If we can get through October and, for a little insurance, the US election on November 6, prospects for the US market may look a little brighter.

All this adds up to an intriguing finish to the calendar year. If the US market can survive October, it may move gradually higher. This would be the ideal platform for the Australian sharemarket, encouraged by a series of interest rate cuts, to start its long-awaited outperformance.

If the US market is able to notch up a 10 per cent gain next year, the Australian market could easily do 20 per cent.

With the S&P 500 companies trading on an average price-to-earnings multiple of about 17 times, compared to an average of 12.5 times for Australian companies, this scenario sounds imminently plausible.

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