Australian breakout or American relapse?

While the signs point to a looming correction, there are gains to be made in this market before we hit a crossroads.

PORTFOLIO POINT: Speculation of a correction has unnerved markets, but regardless of whether the secular bear market continues – or a new bull market emerges – there are gains to be made in 2012.

The Australian All Ords index responded to the surge in American shares by recently breaking through 4,400 (although it closed today at 4327.6) – the upper barrier of the 4,000 to 4,400 range within which it has been trading since August 2011.

The take-off in the US sharemarket since October 2011 caught many by surprise. The European and Japanese recessions, a spike in oil prices and mounting tensions over Iran’s nuclear program blinded analysts from the simple fact that central banks around the world were flooding the planet with money, which found its way into shares.

The following chart shows how the central banks of China, Europe, the US and Japan have expanded their balance sheets between two- and four-fold in the last five years. The expression 'expanded their balance sheets’ is a polite way of saying printing money and lending it to banks and governments at very low interest rates to tide them over. As you can see below, between these four institutions the world’s money supply has been boosted by over $8 trillion in five years. Including the efforts of the next four largest central banks, the total exceeds $10 trillion.

Yet there are still naysayers who warn that this stoking of markets is close to running its course. One is John P. Hussman, who heads Hussman Funds. He thinks that the present landscape ranks among what he calls "A who's who of awful times to invest", along with such unpropitious periods as 1973-74, 1987, 2000-02 and 2007-09.

Hussman’s conclusion is based on five indicators, which he says picked each previous occasion when the market got irrationally exuberant and subsequently crashed. The exuberance threshold for each indicator is given below, followed by its present value:

'¢ The Standard & Poor's 500 stock index trading at more than 8% above its 52-week exponential moving average trendline; it’s now almost 14% above that threshold.

'¢ The S&P 500 up more than 50% from its four-year low; it’s now more than 200% higher than its low of early March 2009.

'¢ The "Shiller price/earnings ratio", based on the cyclically adjusted trailing 10-year earnings being greater than 18; it's currently over 23.

'¢ The 10-year Treasury yield higher than six months earlier; the yield rose from a low of just over 1.7% in Sept 2011 to a high of 2.4% in March and is now 2.2%.

'¢ The Investors Intelligence's bullish advisory sentiment over 47%, and bearishness under 25%; on the latest available data, the numbers were 48% bulls and 27% bears.

One might add that since the US market has been hugging the top of its red Bollinger band since the start of this year, it could be due for a respite, though on the previous occasion that happened it lasted for about twice as long. Also, the dip in the middle of the period proved short and shallow.

A Bollinger band is simply the normal range around a market’s short-term trend line. The closer the index moves to the upper band, the more overbought the market, and the closer the index moves to the lower band, the more oversold the market. You can read more about Bollinger bands here.

The Shiller P/E ratio is named after its designer, Yale economics professor Robert Shiller, who correctly called both the dot-com and housing bubbles. Instead of using earnings for the past 12 months like a conventional trailing P/E ratio, the Shiller P/E uses inflation-adjusted earnings of the past 10 years. Here's what the ratio looks like since 1881; its long-term average value is about 15. You can check its latest daily value at www.multpl.com.

Note that anyone who bought a large portfolio of shares on any of the three occasions since 1881 when the Shiller P/E fell to between 5 and 7 enjoyed a huge stockmarket windfall thereafter, because such lows marked the end of a secular bear market. Ed Easterling of Crestmont Research says the current secular US and global bear market that started in 2000 won’t end until it’s had such a moment.

The US market’s present confidence is also borne out by its VIX index – a barometer of investor fear – which in March got below the reading it reached in April 2011 before the Eurozone crisis erupted. Though it’s risen slightly since then, the index is still at one of its most relaxed levels in five years.

Next, a running survey of members of the American Association of Individual Investors (AAII) shows that bearish sentiment sank to 17.2% in early January. Since then, it has risen to 27.8%, but that’s still under its long-term average of 30%.

So the bottom line is that most investors feel good about the market, but according to Hussman it’s exactly at such times we should be especially wary, because markets always exhibit overconfidence before a crash. To quote Warren Buffett, “be fearful when others are greedy and greedy when others are fearful”. In other words, be suspicious of the market when most investors are bullish, yet receptive to it when most are bearish.

Yet Australia’s own VIX (fear) index at roundly 14.9 is lower than America’s at 16.7, suggesting that Aussies are even more bullish than Yanks, though you wouldn’t think so based on comparative stockmarket performance.

The US stockmarket had its best first quarter in 14 years; the Dow was up 8% and the S&P 500 rose 12%. The Nasdaq composite index, made up of technology stocks, skyrocketed 19%, its best result since 1991. US brokers were ecstatic.

Since its low of 1,100 in early October 2011 to its high of over 1400 in early April, the S&P500 has risen by 29%.

Several US brokers remarked to the media “who could have predicted that?” Well actually, US trend-followers we monitor got back into the market within a week or two of the market’s low of October 3 2011, after escaping most of the 18% correction before then. They didn’t foresee it, but once the surge started they rode the wave, leaving sceptics in their wake.

While American investors who got on board early are celebrating their good fortune here in Australia, the champagne corks are still not popping. Yes, the All Ords index was up by 7.4% in the March quarter and is 12.4% higher than its low of September 26 2011. But that falls far short of what America has notched up. Furthermore, our market only recently retested the ceiling of the flat band within which it has been oscillating since August 2011.

America’s S&P 500 is now only 10% off the historic peak it reached in Oct 2007. Many technical analysts are certain it will not only repeat this achievement, but set a new record high in 2012. Meanwhile, it may fall back to catch its breath before mounting a final assault on Everest.

A possible path the S&P 500 could take from here is drawn by our friend Robert Dillon of StockMarketTiming.com, who tracks the American market. In Robert’s opinion, after 2012 it will either be the start of a new secular bull market, if the index kept rising, or be a continuation of the present secular bear market if the resistance line (B - D) defined by the 2000 and 2007 peaks holds firm. On this view, there is still scope for a further bumpy advance of the S&P 500 in 2012 before the market booms or busts in 2013.

* This is an edited version of an earlier article. All data accurate as of Saturday, April 7.

Percy Allan AM is chairman of MarketTiming.com.au. For a three-week free trial of its services, click here.

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