Hold On Tight

As I see it, we're heading for a sharp correction after March; the broad ASX200 index of large Australian shares will fall from a high of around 5285 to as low as 4150 by October. It may not be the end of the world; but an unheralded correction of about 20% can demoralise or hurt a lot of people.

At present the ASX200 is trading around 4860, the remaining upside from today’s level is 6–10% (say 8% on average).

That remaining potential short-term capital gain still looks enticing to traders when compared with either funding costs or with alternative less-risky returns. It will probably keep them committed right up to the market peak next month. It’s always the prospect of gain, and never the possibility of loss, that keeps people in the market for too long; and when the market mood shifts, as it inevitably does, it’s the likelihood of loss that keeps us out of the market when we should be buying again. But what about the downside prospects from here?

After the market peak is reached in late March, I see the first corrective 7–10% downleg to 4825 hitting fast and hard into April and May, rather like the unexpected corrections of that magnitude that we saw in March-May and again in September-October last year.

But because the complacent consensus has learned to buy the dips in what’s now "self-evidently" a permanent bull market, there will then be a bounce of relief, only this time I believe it will stop short of the previous high, and will even probably fail to get through 5000. But that failure to recover will set off alarm bells among the many technical analysts. It will confirm that the mood has turned bearish, and the market’s short-term moving averages will start falling.

Many exposed trading positions will start to be liquidated as margin calls are made by lenders, and potential buyers will hold back in anticipation of lower prices. Long-term investors, of course, should remain broadly unaffected by what may still be considered to be little more than ordinary “market noise”.

I expect rather stronger support at the 4550–4650 level on the index to hold the market into mid-year as the second downleg develops, a fall of another 8% or so from the peak of the failed bounce. While the size of the drop from the March cycle peak, which will now be approaching 10–15%, will by now no longer popularly be viewed as ordinary volatility, a partial return of confidence that the correction might be contained to no more than this is now likely to spread.

After all, the fundamentals will not have changed materially for the worse by mid-year; and while the overblown earlier expectations of pleasant surprises might have been dashed, at least the market price has adjusted and the risks have fallen. Another bounce, this time to the earlier April-May support line around 4825, is now attempted on the back of this revival; but its failure to break up through that level is seen to provide fresh evidence of the real underlying bearish trend, and the slide again gathers momentum.

This time the aggressive traders capitulate and turn their attention to making money on the “short” side of the market. The trend-followers do likewise. Instead of buying the dips, everybody now sells the weak rallies. Those who bought a stock for a quick trade now find themselves describing it as a long-term investment if they can still afford to hold it. Even the long-term investors suspend their normal buying in the face of the market’s spreading pessimism.

The corrective phase '” and again, I repeat that this is not yet a bear market! '” eventually terminates in October-November at the technical target level of 4150–4300 and then heads weakly into 2007, with the hard-hit resources stocks and banks recovering earliest and with gradually improving market breadth.

STATELY ADVANCE

What I’ll call the Australian Millennial Bull Market, which ran from the end of 1990, ground its way higher for over 10 years with an average monthly gain of 1.1% to a high of 3480 in June 2001. It was a well-ordered, stately advance within a nice tight price channel, confirmed all along by a smoothly rising 200-day moving-average line which reliably “supported” the mild periodic corrections. The home economy was performing well, inflation was receding, the bond market was supportive and profits were growing steadily, together with dividends. In the United States things looked even better.

There was talk of a New World Order, of Peace Dividends, of infinite profitability flowing from technological marvels, of Productivity Miracles, and of the banishment of the business cycle as well as the eradication of investment risk. The Australian market’s performance was helped by this enthusiasm even though most investors thought its prospects rather dowdy compared with the American NASDAQ index. Australia’s small economy was, after all, quaintly olde worlde by contrast, and its market was dominated by tedious financial, mining and property stocks.

Then came all the global concerns about the Millennium Bug, then the great crash of the NASDAQ’s technology stocks, the US corporate scandals and the progressive unwinding of massive leverage in the American derivatives markets, all of which combined to blast more than 50% off the broad S&P500 large-capitalisation index in the two years to the bear-market low in October 2002. The September 2001 attacks by the Al Qaeda network didn’t help either, though the bear market was well established by then around the world.

Of course our own market was affected by all this evaporation of global confidence, and the September 2001 shock chopped more than 17% off the index. But that was a pretty mild reaction compared to the US S&P500’s 28% plunge, and our broad index went on to recover its initial losses within five months before joining the rest of the world in the savage subsequent 2002 bear market, which saw us lose 23%.

Not only was the Australian experience less than half as severe as the American one, since we had less far to fall, but our recovery has been astonishing, for all the many reasons I advanced in last September’s article (click here). The US market is still about 17% below its previous high point in 2000; our own is well over 40% above the old bull market high, and if my prophecy is correct, will peak at nearly 50% above that level by the end of next month. Since the early-2003 bear market low, it will have virtually doubled: from 2693 to the target average of 5285.

But that’s the problem, and that’s where it ends for this year. The rate of advance has more than doubled since the end of the bear market, from an average of 1.1% a month in the five years to the mid-2001 peak, to an average of over 2.3% a month for the past three years. That new rate is unsustainable in a slowing economy with mounting debt problems and rising inflation and interest rates. As a matter of interest, a simple extrapolation of the old line of advance would today have the broad market nearly 500 points lower, at about 4400 on the benchmark index.

PROBLEMS EMERGE

Two other problems have begun to undermine the case for permanent bullishness. One is that the market has become intensely polarised, as was the US market before the technology crash, into increasingly overbought fashionable stocks and sectors at its leading edge, and into a badly lagging trailing edge of disregarded companies. The “market breadth”, in other words, has been degenerating badly for many months, and this non-confirmation of the advance is never a good sign. Markets in which the good news is so highly concentrated among a few stocks are vulnerable when the good news stops flowing.

The other problem, and the one to which I ascribe the greatest weight '” being an old and unreformed contrarian '” is that nobody seems to be concentrating on these risks. I have seldom seen such a degree of complacency.

Many eternities ago '” back in June 2005, although the article wasn’t published in Eureka Report until September '” I argued strongly for my view that the broad Australian sharemarket index was likely to keep rising “at least another 15–20 per cent before it begins to look at all speculative in the context of historical valuations”. From its then level of about 4500, that confident prediction set a peak value of between 5175 and 5400 on the S&P/ASX200 index in question.

Not quite six months later it is now about 4850, less than 6% below the “low-end” target and within 10% of the higher forecast. The year’s high-water mark of 4983 has already got to within 6% of the average of those targets. Does this mean I should join the galloping herd and nudge the forecast higher? Why not just remain popular by urging people to disregard the growing risks '” after all, the market background looks promising, according to all the late converts to the bull case.

Actually, I see no good reason to keep extrapolating the recent price history in the sort of enticing straight line that grows to the sky. Markets don’t work that way. Once they deliver what most of the serious players expect, they run out of breath, flop about in self-doubt, and retreat '” even if the “fundamental” news remains good and healthy. It takes bigger and bigger positive surprises to keep them going to new heights while it takes only minor disappointments to set a correction in train. And while I can still see the conditions for those predicted new highs to be achieved very soon, I also sense the approach of a series of “normal” corrections to this bull market as happy surprises fail to eventuate. This doesn’t mean, however, that I expect a nasty new bear market to develop '” not yet, anyway '” although the correction will be sharp and deep enough to feel like one, especially to those who have ventured too far out along the risk curve.

Prophecy has always been a thankless task since those who attempt it publicly are seen as quacks, fools or agents of the devil. Those of us who lack that conviction, and who only venture views in private, are instead seen as harmlessly delusional, even-handed economists or stockbrokers. Yet the investing public reasonably requires that the professional reveal his cards on demand as a token of his courage – as every prophecy needs to be clear and testable to be useful.