Four reasons this market will move higher

2014 has certainly been a very benign year so far – the most carefree since pre-GFC days.  

Consequently, market gains have been good, but not necessarily spectacular. At the time of writing, the All Ords was up between 5-6%, or closer to 8% on an accumulation basis. That’s not too bad, and annualises to a 12% return assuming we hold that momentum.

Luckily for investors, there is every reason to think the market should, at a minimum, hold that momentum coming into the final third of the year. In part that’s because there seems to be a kind of end-year seasonal pattern (tied up with a Santa rally) that has been established in three of the last four years – one of outperformance.

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More likely though, the end-of-year rally could see stronger momentum than what we have seen thus far – and there are four changes to the investment landscape that I think will drive this.

1. Bears have capitulated. These days no-one suggests that a bear market is a reasonable proposition – at least in the near term. People may debate the cause and support of this bull market, but no-one doubts its existence, or the fact that it will continue in the short-medium term (barring natural disasters or war etc.).  That being the case, there is plenty of support at current levels, and not a great deal of resistance to the next break-out when that occurs.
2. If we take the US Federal Reserve and Bank of England at their word – cash rates will rise at some point over next year. Investors won’t need to necessarily worry about this having a negative impact on the market however. Sure, it’s tricky and central banks are the key threat to investors. But, at this point, I’m not seeing anything in their rhetoric or the data that is malign or in any way suggests this tightening cycle will actually be a negative for the market. Normally a lift in cash rates isn’t good for the market, that’s true, but we’re not in normal circumstances at the moment.  In previous years when a tightening cycle has begun, there was the threat that monetary policy would move from a stimulatory to a restrictive setting. This time around I don’t think anyone is forecasting that rates will move into restrictive territory over the medium term. Rates are ultra-low, record lows in some cases, and they will likely remain low years after the first hike. With that in mind, I doubt investors will be concerned over tight policy as such. Instead, the focus will be on what must be the very positive economic backdrop – that is, if excessively dovish central banks are actually tightening policy, then things mustn’t just be good, they must be outstanding! You’ll see the language that central banks adopt change markedly. One area of the economy that comes to mind is the labour market. The Federal Reserve is hesitant, and at this point offers mixed rhetoric on labour market health. In the build-up to the first rate hike, that language will change and this in turn will change the economic debate, and give sentiment a boost.
3. Weight of money will increasingly hit the market. Cash holdings in the US and Australia are still high relatively, notwithstanding record low interest rates and a booming share and property market. In the US, cash holdings as a percentage of total financial assets are nearly 1% higher than the immediate pre-GFC average. In Australia, cash holdings remain elevated at 14.6%, although down from recent peaks closer to 16%. Still, that’s almost double what we saw in 2006-07. There is ample scope for this cash to hit equity and property markets, and I think it will. Perhaps not to the extent that we saw pre-GFC, but it is likely to lift. The great irony is that it is often rising interest rates – off a low – that set such things in motion.
4. Fed-European Central Bank divergence will lift volatility. Normally volatility isn’t a great thing for the market. Too much of it can scare investors away, as we saw throughout the European debt crisis. Not enough of it also seems to spook people – it’s eerie, let’s face it, and we’ve seen the commentary associated with low volatility. The initial view this time around was that low volatility was the herald of impending doom. Market commentary has moved on a little from that perspective, and perhaps that’s because of the growing view that the Fed and Bank of England will diverge from the ECB and Japan in their rates stance. If that does eventuate, we will of course see currency and rates markets whip around. There will be plenty of volatility – lots of excited commentary on the relative attractiveness of Europe and American equities. It’s a win-win situation though. The market gets the volatility it needs to be liquid and it gets ongoing injections of free money, despite the Fed and BoE tightening.  While some regions will outperform others, equities as a general asset class will move higher as a result of the divergence.

Now, I appreciate that these are all global factors, but our market is small and it is global factors that dominate. The above factors matter and, taken in isolation, will be very positive for sentiment toward equities more generally – our market will benefit from that, even if Aussie stocks do underperform. But I’ll talk more on that another time.