When will the market party end?

The market rally will end sooner or later … here’s how to prepare for the next dip.

Summary: Depending on who you believe, the sharemarket either still has a long way to run or it is on the verge of a big correction. The cases for both points of view are compelling, so investors should be prepared just in case. There are three key strategies to consider.
Key take-out: Stick with the market, but only for as long as its stays on the right side of its medium or long-term price trend.
Key beneficiaries: General investors. Category: Strategy.

The Australian All Ordinaries share index has risen by around 32% in the last 18 months. The S&P 500 index, expressed in Australian dollars, is up 38% over the same period. Welcome to boom land, with no end in sight.

But all stockmarket rallies end with a correction or crash. And America’s market normally leads the dive.

The present cyclical upturn dates from March 2009, when sharemarket indices bottomed after more than halving from their peaks of October/November 2007. There were subsequent price corrections, but none amounted to a crash. The latest stock rally started in mid-2012.

Not surprisingly opinion is divided on when the next bust will occur.

Those who think it’s at least six months off argue:

  • US shares don’t look excessively valued by historical standards on a nominal price to 12-month trailing earnings ratio. Nor do Australian and global sharemarkets.

  • Shares continue to be more attractive than cash, term deposits and short-dated bonds whose interest rates remain at historic lows. Longer-dated bond prices have fallen significantly as their yields have crept off the floor, prompting investors to switch from bond to share funds. There is no evidence yet of this trend reversing.
  • Gold and other precious metal prices have collapsed and the US property recovery is stalling as mortgage rates rise. Hence shares remain the most attractive asset class on the menu of obvious choices.
  • The best season for shares is November to April (since 1950 virtually all market gains occurred over this six month period). May is still more than five months off, so the chances of a correction or crash look low before then.
  • The change of government in Australia has boosted business confidence. According to the Trader’s Almanac the US stockmarket best likes a Republican Congress and a Democrat President. Also by mid-term Congressional elections (due 4 November 2014) the stockmarket normally picks up, so based on history it should be blue skies ahead.
  • Central banks will do whatever it takes to avoid a stockmarket correction, let alone a crash, because of the fragile state of global recovery. Central bankers fear deflation more than inflation so will continue keeping cash rates low and money printing high to stoke economic growth.
  • The S&P 500 index has broken well above the trading range established by the 2000 and 2007 peaks suggesting that the secular bear market has morphed into a secular bull market that could run as long as the golden age of share ownership from 1982-2000. Both US and Australian sharemarket volatility (VIX) indices are low, confirming that fears about the GFC have finally abated. It’s full steam ahead.

Those who argue a correction or crash is imminent say:

  • “At the market's recent high, the Shiller price-to-earnings ratio (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) of 24.6 matched that of September 1929 (a month before the crash that would lead to the 10-year Great Depression), exceeded the peak of 23 reached in March 1937 (the S&P 500 lost half of its value over the following year), matched the extreme of May 1965 (which ushered in a 17-year secular bear market) and significantly exceeded the level of 19.8 seen at the August 1987 peak (right before the global crash)” according to Bill Hall, Money & Markets, 23rd October 2013.

  • Not only is the Shiller P/E at peak levels, but corporate earnings are too, which makes the Shiller valuation level even more alarming. US corporate profits (measured as a percentage of GDP) are nearly 70% above their historical norms, which on prior occasions led to subpar profit growth over the next four years.

  • Long-term bond rates are rising and there is nothing central banks can do to stop this since creditors believe inflation is set to rise over this time frame, so are demanding a higher yield to compensate for it. Central banks can’t keep flooding their economies with fiat money because they risk a debt-fuelled asset price bubble that could set up another global financial meltdown.
  • Stockmarket corrections of 10% to 20% occur almost annually and crashes of over 20% (averaging around 32%) typically happen every 3-4 years. Since the last correction was in mid-2012 and the last crash began in late 2007, both events look well overdue.
  • The market is becoming irrationally exuberant. Twitter attracted over $18 billion for its IPO. Australian finance sector stocks are up almost 80% since their last trough in September 2011. Analysts accept that the market is strong because of an explosion of global liquidity and record low interest rates, not an improvement in corporate profitability. In addition, Australia faces a slowdown because its mining investment boom is over.
  • The US Investors Intelligence Advisers Service reports the proportion of bears is down to 16.5%, the same complacency levels recorded before the correctiosn of 2010 and 2011 and the crash of 2007. This is classic “calm before a storm” phenomena.

  • Junk bond debt is at an astronomical high and is susceptible to a price collapse should bond yields climb back to more nornal levels. Such an occurrence would not leave shares unscathed because equity ranks on par or below such debt on the security totem pole.

So what should you do?

There are three possible responses:

  1. Start taking money off the table, just in case. That’s prudent, but the last leg of a rally is usually the most profitable. Also, if this is the start of a new secular bull market, you could miss out on huge gains. In any event, trying to second guess the market is a fool’s game. Few succeed at doing so.
  2. Commit to holding onto your share portfolio through thick and thin. That certainly works on most occasions because the market has always bounced back. Yet there have been times when that took up to 20 years, which is too long if you are in or near retirement. In Japan the Nikkei share index is still only one-third its value in 1990. Also, not everyone has the temperament to withstand a large share loss. Investors often panic and capitulate towards the bottom of a crash and then are too traumatised to get back into the market before it rebounds.
  3. Trend follow the sharemarket so that you exit early in any correction or at least early in any crash. This involves using a moving average trend-line (say 80 trading days for active timing and 200 trading days for conservative timing) for the All Ords index.

Whenever the index sinks below that plimsoll line move your equity portfolio to either 100% or 50% cash to protect your wealth. Likewise, whenever the index moves above this line buy back into shares (preferably through a low cost highly liquid exchange traded equity fund that gives exposuer to the top 50 to 300 Australian shares with just one stock market purchase).

Admittedly slow trend-trading generates whipsaws (small losses when the market changes trend, but not for long enough to generate a profit or saving) but such drawdowns are modest compared with the large savings (and emotional relief) from avoiding a big bust.

Decide now how you are going to cope with the next stockmarket correction or crash. Otherwise you risk becoming a hostage of your own emotions, which are a dangerous guide for dealing with a market crisis.

My advice – stick with this boom, but only for as long as its stays on the right side of its medium or long-term price trend.

Percy Allan is a director of MarketTiming.com.au For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds, see www.markettiming.com.au.

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