This weekend's news from Cyprus has opened up another front on the assault against the current uptrend.

The question before traders is now whether history will see today's trading as just another  red candle in the broad sideways movement that began on 20 Febuary or something that finally leads to the much anticipated correction.

I've posted some brief thoughts on the technical outlook for the index and a couple of perspectives on recent news events.

Daily Chart

The index showed some clear signs of weakness in recent days. We finally broke below both the trend channel that has defined the rally since 20 November and the 20 day moving average.

Australia 200 CFD Daily 18 March Australia 200 CFD Daily 18 March

Even so, it's early days in calling a major correction. If markets hold at current levels or not far below, today's sell off may look like just a part of an ongoing pattern development.

In the chart below, I've put a trend line across recent trend peaks to give a sense of how this sort of pattern could be developing. A short term bounce from here, for example, could bring a head and shoulders pattern into play.

At this stage though a break below the 4974 support would put this question to bed. This would make it more likely that a corrective move lower is underway. Waiting for this evidence may seem pretty conservative.  But if there is going to be a correction, a move back to the 38.2% to 61.8% retracement levels still gives plenty of scope for a deeper move.

Australia 200 CFD Daily 18 March Australia 200 CFD Daily 18 March

Valuation theme - Cyprus and last week's employment figure may both be short term game changers

Cyprus

The core theme for the Australian market in recent months has been a rally driven by increased valuations not by a big improvement in the outlook for corporate profits. This increase in valuations has been a response to a lower global risk outlook.

If the situation in Cyprus develops into something with implications for wider Europe, the lower risk outlook may be at least partly removed. If that happens, there's certainly potential for a decent correction.

Much has already been written about the European bailout requirements for Cyprus and no doubt a great deal more will be, so I'll confine my observations to one perspective.

One of the major sources of risk in Europe is political. This is effectively the risk that the politics of the creditor and debtor nations can't be aligned forcing some sort of crisis.  In that context the idea of a levy on deposits seems very graphic and potentially a lightning rod for opposition. It's one thing to reduce future income via a tax; it's another to take a swipe off existing personal bank balances. This may strike a chord with middle class voters in other countries as well.

Last week's employment figure

Very low interest rates on fixed interest investments have been another key driver of increased Australian share market valuations.

It's quite likely that last week's 70,000 jobs growth number will turn out to be at least partly a statistical sampling issue. Even so, markets and the RBA have been put on notice that the employment outlook may be improving. Unless future employment numbers  substantially reverse last month's figure, markets will be assuming that interest rates have bottomed.

This potentially removes the main foundation of another large and fast leg up in the share market happening soon. Although share market earnings yields are above the long term average, they are still quite cheap in relation to bond yields. This meant valuations could have kept moving higher if rates stayed very low or looked like getting even lower. If rates have now bottomed and bond yields continue to creep higher, then valuations will find it harder to expand at the rate they have in recent months.

In this scenario the index will rely on an improved earnings outlook to push it higher. That may happen but would likely be a more gradual process.

Risk: Reward

From a near term trading perspective, these two news events have changed the risk: reward balance, I suspect

If Cyprus turns out to be a non event, the near turn upside may be fairly limited given the possibility that interest rates have bottomed.

On the other hand, looking at the charts and with forward PE values above long term averages, there is scope for a relatively brisk and steep correction if news flow is poor. Some of the news events that could turn out to be trigger for correction in the next few days include:

  • Cyprus voting against austerity measures
  • This week's Fed meeting
  • A disapointing Flash PMI from China.