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Knife Stick

Knife Stick

Investors waiting for market to turn should be on alert – because there are early signs of a market bottom. Just as price falls without apparent reason are a sign of weakness, markets that rise despite poor data are exhibiting strength. And that’s exactly the action in the Australian share market in the opening sessions of this week.

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On this daily chart the last 4 candles (days) are blue –  meaning a rising day. The consistent size and steady rise is in sharp contrast to the previous trading in 2016. Note the green “w”. This was generated by CMC’s pattern recognition scanner, and is recognising a double bottom formation. Combined with rises in share markets around the globe, and a steadying of commodity prices, there are both technical and fundamental  signs that the worst of the pressure on share prices is over.

In other words, if the knife was falling, it may have just stuck.

Market timing always presents challenges to investors. Some investors will wait for clear signs that a market has turned before buying. The problem is that we never know if a market bottom is in place in real time – it becomes apparent only after the market makes a sustained move higher. The danger in refusing to “catch a falling knife” is that by the time a market has clearly stabilised it may be 5% to 15% higher.

Investors attempting this market timing (as opposed to buying when desirable shares get to attractive levels) may need to move quickly. If investors still wish to hold off, it may be a sign of a bigger issue.

Trading and investing are different, albeit overlapping, activities. There are areas of commonality. Managers of newer traders are usually faced with one of two problems. Firstly, there are traders who are too enthusiastic. They’ll trade any opportunity, and often end up overcommitted. The other problem is the reverse. Some traders cannot find a trade – there’s always a reason why a trading idea is not good enough. Theses traders are plagued by “paralysis by analysis”.  Investors intending to sit on the sidelines despite this clear change in market behaviour may be suffering the same affliction.

Determining what is the most suitable investment is a function of both market and personal factors. From the market point of view, there is an opportunity at the high quality end of the market. When all share prices are down, blue chip stocks may offer the best  value in any market recovery. There is no need for investors to outsmart themselves.

In terms of sectors, with the exception of healthcare stocks, there is valuation support at current levels. If the commodity cycle is at or near its low, many energy and mining stocks are at prices long term investors may consider a bargain. Industrial and retail stocks have recovered somewhat over the last year, but look low against historic valuations. The right choice in both individual stock and sector for investors will also depend on existing investments.

Portfolio considerations

The market pullback is an opportunity for investors to remedy portfolio imbalances and gaps. Some common issues investors face include:

Narrowness – the portfolio is focused on a handful of stocks. At current prices, four or five stocks account for more than 75% of the portfolio value. This may be a deliberate strategy, taking a higher risk approach in an attempt to capture higher returns. However, investors accidently in this position are looking at an investment candy store, with excellent opportunities to diversify into other stocks and sectors.

Lack of balance – there is a reasonable number of companies in a portfolio, but they are exposed to the same market drivers. An investor may have a 25 stock portfolio, but it is 8 bank and insurance stocks and 17 property trusts. These stocks are correlated – they tend to move in the same direction at the same time. A surprise lift in interest rates, for example, could see significant damage to the portfolio. Investors in this situation may consider selling some existing holdings to diversify into other market exposures.

Overgrown  – the portfolio has not been tended for some time, and has many small holdings that because of their size cannot make a meaningful difference to the portfolio. These investors need to weed their portfolios. Current market levels are an opportunity to cull insignificant holdings, and move more into the stocks and sectors most suitable, focussing on core stock holdings.

After significant falls a period of stabilisation  at lower levels is possible – but so is a straight rise. Given expectations of increasing volatility over 2016, I lean towards the latter. This could mean investors who fail to act now will miss the boat.

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