Traders are now confronted by a combination of improved valuations, declining volatility and rejection of chart resistance. A decent pullback in the Australia 200 is a growing possibility.

 

Volatility

 

Stock market commentary over the first couple of months of this year invariably talked about volatility. This reflects the 3 strong directional moves in the ASX 200 index since mid-December.

First there was the “Santa rally” where the index gained 8% in the space of a couple of weeks. It then promptly fell 12.5% to a low of 4706 by early February.  The third directional move has been the recent recovery. This leaves the ASX 200 9% above the February low and down only 3% for the year.

It is possible to have quite strongly trending markets without high volatility. This occurs when the percentage change in each day’s price movement is relatively constant. Recent months have not been an example of this. Markets have felt volatile and statistical analysis bears this out.

The chart shows 30 day historical volatility for the ASX 200 over the past 10 years. This plots actual volatility and is different to the implied estimates of future volatility used in the widely watched VIX “fear Index”

ASX 200 30 day volatility Source: Bloomberg ASX 200 30 day volatility
Source: Bloomberg

Historical volatility peaked at 60 during the GFC.  Greek and European debt crises versions 1 and 2 resulted in major volatility peaks of 27 and 31 respectively

The first year in the 10 year period takes us back to more gentle, pre GFC times. That year, volatility averaged a sedate 13. Interestingly the last 4 years have been pretty similar, averaging 14.

Volatility has been elevated over the past year though.  Over the past 12 months it averaged 18 and peaked at 29 in September. This was associated with the 14% sell off in August/September.

So far this year, historical volatility has averaged a relatively high 19. Not surprisingly, the greatest volatility has been in the Energy sector which averaged 43. However, there was elevated volatility in most sectors. The two other standouts were materials averaged 31 and the financial sector which has been pretty whippy at an average of 23.

What’s interesting now is that average volatility has fallen sharply over the past week. Thirty day volatility for the ASX 200 index was down to 16. This is the lowest read since the beginning of the year.

Declining volatility after strong trending behaviour is often a warning sign that a trend is close to ending. It shows a new period of indecision. Buying power is running out of steam. Prices are better reflecting consensus fair value. In these circumstances negative news or even just a lack of news, can trigger profit taking and strong initial downward momentum. The alternative is a period of ongoing price drift as markets stay stalled.

 

Valuations

 

Throw into this mix the fact that the recent rally has pushed valuations well above recent averages. The ASX forward PE is now around 16.7 times forecast earnings. This compares to an average of 16 since the beginning of last year. With the next Fed rate hike looking likely over coming months and other risks like Brexit and China’s economy in focus, valuation upside is starting to look limited.

Source: Bloomberg Source: Bloomberg

 

Australia 200 chart

 

With valuations above average and volatility declining the index is rejecting chart resistance today.  This resistance is made up of the 200 day moving average and the 78.6% Fibonacci retracement level.

Today the Australia 200 has broken below the top of a potential support zone between 5080/5045. A break below the bottom of this will indicate a significant correction of the whole 4700/5226 rally. By that time, the slow stochastic in the box under the chart which has already broken below channel support will also be under 50% lending weight to the possibility of more downside to come.

The sideways drift alternative scenario would see the index chopping back and forward through the 200 day moving average but holding above the 5050 support for a while yet.

Australia 200 CFD Daily Australia 200 CFD Daily