Market rumble a call to wake up and pay more attention

There is a debate going on as to whether the recent market fall was simply a "Moment" in the market or "The Big Top".

The argument for the Big Top is that the US economy has been gorging on cheap money provided by the Federal Reserve and some of it has spilled over into the equity market. Net result the US S&P 500 index is up 153.3 per cent from the GFC low in 2009 and continues to hit new record highs.

That's why the market is worried about the end of quantitative easing and why brokers have been circulating charts of the correlation between quantitative easing and US equity market rallies.

Great theory except for one problem, while the Australian market has fallen more than 6 per cent from the top, the US has continued to hit new highs. In Australia, as we write, "safe" stocks such as Westpac have fallen 16.8 per cent from top to bottom, ANZ 13.8 per cent, NAB 11.2 per cent, the CBA 9.9 per cent, Telstra 7.5 per cent, Woolworths 11.6 per cent and Wesfarmers 9.5 per cent. And some of those high PE low-yield quality-growth stocks that were supposed to be safe such as iiNet fell 24.7 per cent, M2 Telecommunications fell 25.4 per cent, Amcom fell 24.5 per cent and REA Group fell 21.4 per cent, to name just a few. They aren't the most liquid of stocks at the best of times. It's almost as if some fund manager just decided to dump everything in one hit.

What is going on? Why are we in free fall while the US holds firm?

Look no further than the Australian dollar. Since April 11 the $A is down from US105.85¢ to US95.28¢ at its most recent low. That's a 10 per cent fall in just over a month. "But that's supposed to be good news," I hear you say. Wrong. The relationship between the equity market and the Aussie in the short term has nothing to do with the long-term impact of a lower Australian dollar on the profitability of Australian listed companies, it is on the short-term impact it has on international fund managers.

When international fund managers expect a fall in the $A they sell Australian assets, all Australian assets, with equities being the most obvious. International money accounts for 40 per cent of the Australian sharemarket and is a lot more mobile than domestic funds management money, so it matters.

Domestic fund managers, on the other hand, are benchmarked to Australian indices like the All Ordinaries Index. Their target is relative performance, relative to the index. If the market falls they succeed if they lose less.

Domestic fund managers are not threatened by a fall in the currency, or the market, just by their funds underperforming, losing more money for their policyholders than the market and their competitors. So when the market falls, domestic fund managers just sit.

International fund managers, on the other hand, are paid relative to non-Australian indices. At the aggressive end the hedge fund managers are paid on a percentage of the gains they achieve, so they are absolutely return focused. So if the $A falls they lose money in $US. So they sell Australian assets, including equities, and fast.

Other international fund managers (some massive) are benchmarked to the MSCI World indices of which Australia is one small part and of their benchmark and when it comes to asset allocation they take currency risk into account and take it or leave it when it comes to Australia (2 per cent of the World Index).

They could decide to sell everything in Australia and it's a small decision for the fund as a whole. Others may just decide to cut their weighting in Australia from 3 per cent to 2 per cent and in doing so move billions of dollars out of our market.

So when the $A falls, international fund managers sell Australia and that's what has happened. Clearly they had big holdings in the big index stocks and some of them had big holdings in quality growth stocks and they got smashed. So this isn't a Big Top, it's a currency tumble and, other factors aside, we should watch the Aussie for the turn. That aside, the action in the past week is a stark warning about how unsafe the market actually is, even at the quality end. I don't want to scare you, but last week was a wake-up call and it's too cute to just move on, advise everyone to buy and book another commission. It is time we all sat up and started to pay attention again.