It is becoming increasingly dangerous to ignore the Australian sharemarket because of its recent moribund performance. Since June 4, the S&P 200 index has rallied a nifty 10 per cent on expectations of northern hemisphere central banks injecting a speedball of adrenalin into markets to avoid another economic calamity.
As has been the case since the crises in 2008, what the financial markets want, the financial markets get. Europe, the US and, to a lesser degree, China have all stepped up to the plate and started to pump money into the system.
Most of us, including me, have strongly argued that such a market rally is hardly the building blocks of a sustainable bull market. Seemingly insurmountable problems still need to be resolved and until then, stay clear of equities. For the best part of four years, most of us bears have been forced to choke on humble pie. Nearly all the major global markets have rallied, gaining from 50 to 100 per cent.
The Australian market has been at the bottom end of this range. It is easy to build a bear case for the Australia market with an economic slowdown on the back of decelerating mining activity and an elevated currency that is cruelling many domestic business.
Now though is not the time to shut the door on equities. From a technical standpoint the S&P 200 index is approaching the critical juncture of 4440 - the impenetrable ceiling for most of 14 months. At the time of writing, the index was a miserly 1.3 per cent below this level, or a couple of strong sessions next week. If we get through this 4440, we could easily charge through to 5000.
If we fail to breach this level, we could be in for another six months of dreary, soul-destroying choppy markets. But for now, lets stick with the positives.
In a world of so many problems, how could the Australian market power higher by close to 20 per cent? The first positive driver could be lower official interest rates. Three months ago, the Reserve Bank was not even considering further cuts. In the space of just 90 days, though, the economic climate and the risks have dramatically changed. World growth has slowed, especially in China, resulting in a large correction in commodity prices. This has taken the heat out of the mining market, allowing the RBA far greater flexibility to move on rates. There is a reasonable chance of a rate cut this week, but more importantly, the financial markets are looking at 50 to 75 basis points of cuts over the next year. The top end of this range would see domestic cash rates all the way down to 2.75 per cent.
Such low rates could act as a rocket launcher for equities. Firstly, it forces individuals and institutions to take on risk because cash delivers next to no return. Secondly, it should stimulate domestic economic activity down the track. Finally, it may take the heat out of the Australian dollar. For foreign investors, the biggest hurdle to investing in Australian shares is the fact that the local dollar is trading above parity. They are terrified of being long Australian stocks when the currency decides to stumble 20 per cent. Move the $A back down to US90? and this attitude might change. We only have to look at the performance of the US market over the last three years to understand the power of low interest rates.
Another driver of Australian equities will be the US economy and the flood of liquidity from Federal Reserve. Chairman Ben Bernanke is trying to build a bridge to the time when the real economy finds some traction and grows closer to 3 per cent. The main hope is a recovery in US housing market that, while steady, is still well off normal levels. Housing starts, which usually sit at about 1.3 million a year, are running at 750,000. The housing market is the main driver of US consumer activity, which, in turn, is the key driver of global industrial production.
The third major driver of Australian equities is the transparency of bad news. We have all heard of markets "climbing the wall of worry". The list of worries includes governments' debt levels, fiscal cliffs, a Chinese slowdown, a Euro breakdown. Still the US equity market has climbed and climbed and much of the ghastly realities may be baked into stock prices. The final driver of the local equity market is the removal of its biggest negative - a bubble in mining stocks. As has become patently clear, commodities are cyclical whether China is involved or not. Now that they have crashed by 40 per cent, we should view the sector as a mild, rather than raging, risk.
Hardly anyone is a bull at this stage. One well-known US chartist believes a global bear market bigger than 2008 will hit in early 2013. He describes this as the "Jaws of Death." If he is wrong though, we could be in for an exciting time. Whatever you do, stay tuned.