Sighting green shoots in a battered sharemarket

PORTFOLIO POINT: Sharemarkets could rally strongly if QE3 arrives as expected, China stimulates, and European instability eases.

There are buying forces in local and global stockmarkets that could produce a good rally this time around.

I aim this week to isolate what I see as three forces that are driving this share rebound and to explore some of the strategies people might adopt in this situation.

It’s important to underline that if any of the forces turn pear-shaped, or the high-risk situation in Europe explodes, it will blow any rally to pieces. Against that, one of the three forces, and the most important for Australia – China – is performing as markets expect. So why are shares rising after being in the doldrums earlier in the week?

The first point to understand is that we are dealing in a traders' market, so enormous amounts of money are being speculated on individual and global stockmarkets. That’s why you usually see all major global sharemarkets moving in the same direction at once.

When the global markets had such a battering last week, it was partly caused by massive short positions being taken. When you have a rush of buying into the market, then those shorters are forced to buy to cover losses and they often take the reverse stand and go long, so doubling the buying. Accordingly, substantial buying support can be generated in these corrections.

Of course, such a trader-driven correction can easily peter out, but on this occasion the three forces provide the possibility of a sustained rise.

First of all, the US is not falling to pieces, although there are clear indications of softness in various areas. The failure to get the US economy moving is causing markets to speculate on another quantitative easing, or the so called 'QE3’. It’s simply a way to print money, and if that were to happen it would result in another traders’ picnic, with a large amount of the money finding its ways into share and commodity speculation. The Australian dollar would rise strongly. The bad news in the US really kindled QE3 speculation, so in a bizarre way bad news becomes good news for markets. The close links between the traders and those who set policy means that speculation has a higher success rate in the US than in most other major centres.

Our second upward force is the expectation of quietness on the European front for a month or two. Over in Europe, the polls are suggesting that the Greeks will continue with austerity. If that happens, it will be a major boost to the markets because it was the threatened collapse of Greek membership of the euro that triggered the recent share price falls.

Also, in Spain, there are clear indications that another slab of cash is being mobilised to help the Spanish banks. One would hope that this time around the European Central Bank will not simply lend money to banks and have them gamble on high-risk country bonds, but will rather support governments like Spain and have them inject money into bank equity. There is a desperate need for substantial amounts of equity to be injected into most European banks to cover their massive losses. There are clearly a lot of things that can go wrong, and the fundamental problems remain, but if we had a period of stability in Europe and a qualitative easing in America, it would be a recipe for a rise that would extend beyond a correction rally.

Then comes China and, as far as Australia is concerned, China is our major concern. There is no doubt the Chinese economy fell much further than was originally planned. The market assumes that the Chinese will increase their level of stimulation on the basis that the Chinese can’t afford low growth for an extended period because it would cause social discontent. This third force behind the market was given impetus by the decision of the Chinese government to reduce interest rates.

Portfolio strategies? In this situation, those that have very low levels of equity in their portfolio may wish to ride the rally by lifting their equity content, although everyone must understand the long-term risks. My long-term nervousness stems from the fact that if Europe were to blow up – probably via a split in the euro – it would greatly damage the global supply of capital. And holding it together will also be very painful and require extensive amounts of capital.

But right now, it would seem that whenever the crisis gets too hot, the authorities turn on the printing presses. That’s good for shares. Nevertheless, I am not sufficiently confident about the long-term situation to recommend a major lifting of equity percentages. Indeed, those who were uncomfortable with their high level of equity in the tough times last month may use the rally to reduce their levels of equity to where they are comfortable. And, of course, if this rally continues there will be many trading opportunities for those that operate in that way.

Always remember that if there is no quantitative easing, China does not stimulate and/or we have a new round of European instability, then the market is very vulnerable to a fall back. Nevertheless, it is important for Eureka readers to understand that if all the ducks line up, then the market could surge forward, and it is speculation that these events will take place that is the key driver behind this week’s rally.

Note: Last week, I had a mental block and I thank the readers who alerted me. I said Hastie and other companies did not disclose holiday and long service leave. That’s wrong. What they do not disclose is retrenchment entitlements. In a major size reduction or liquidation, these retrenchment payments can savage asset backings and bank ratios.