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Australia 200 - light the wick

Things look good. Markets are up, and the medium to long term economic outlook continues to improve. There’s proof in central bank activity. However the short term direction for share prices is less positive.  Fundamental factors and technical indicators are pointing to a possible market pull back and opportunity for investors.

Both the US Federal Reserve and the People’s Bank of China are obviously confident enough in the underlying strength of their economies to tighten monetary policy.  The US is lifting rates, in China borrowing is tougher. Recent growth and activity data is positive and trending upward. Strength in these two nations is enough to shift the global view.

Even the president of the European Central Bank is leaking hints that the era of accommodation is coming to an end. Given the amount of event risk this year in Europe alone (Brexit, major elections, etc) this is an expression of high confidence. Much better manufacturing and services indices that speak to an ongoing economic expansion underpin the confidence.

 However one plus one does not always equal two. An improving outlook does not necessarily mean a higher share market – at least in the short term. The reason is straightforward. Stock prices accord to the future, not the present. As the numbers late last year started to show stabilisation in China and an accelerating improvement in the US, share markets around the globe reacted.

The rise reflected optimism that arguably included benefits from new US policies. These potentially stimulatory moves are still in the offing, and US markets in particular appear to carry little risk premium for potentially economically damaging mooted trade barriers.

This means we have a US S&P 500 index trading above historical norms, around 20 times earnings. In Australia, the index P/E ratio is less stretched at approximately 16-17 times, but not cheap. And the seasonal positivity associated with the October to April period is coming to an end.

Now, take a look at the technical picture (above). 

The index has approached levels just above 5800 on three occasions this year. On each occasion it has failed to break through. The initial double-top formation could now evolve to a triple-top, with the three peaks already in place.

Naturally, if this is a triple top the index may fall substantially, with targets at 5500, 5150 and 4850. This is my base case – the scenario I think most likely. It’s why I’m a buyer of index put options, which increase in value as the market falls.

How will the market prove me wrong? There are two scenarios. The first is the market climbs the wall of my personal worry, bursting through the recent high at 5832. A daily close above that point is bullish, and negates the triple top formation. That sort of action would see traders looking for a test of 6000 in fairly short order.

Secondly, the market may trade sideways, maintaining the current lower volatilities. A narrow range between 5600 and 5832 would mean little in the way of overall opportunities, making portfolio construction almost purely a stock-pickers’ game. In my view this is the least likely scenario.

The Australian volatility index (AVIX) hit an all-time low last week. Confidence or complacency are riding high. Periods of low volatility don’t last for ever, and can come to end in a step-change for markets. A possible source of a sudden shift in market thinking is the bond market. A recent rally back in bonds and gold suggest not all is well. If rising interest rates spark a rout in US bonds, the sentiment impact could be strongly negative.

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