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Riding the sell down

It’s an ugly start to the week for some investors. Australian shares followed the global lead to sell down on concerns that historic levels of central bank support will soon start reversing.

Ultimately this is a good sign – the US Federal Reserve, the People’s Bank of China, the Bank of Japan and the European Central Bank will only withdraw accommodation and lift rates in response to improving economies. But the transition from Quantitative Easing supported asset prices to values that once again stand on their own could be rocky.

The selling has begun. At one extreme, this could be the beginning of a serious, 10%-20% global pull back, especially if markets take the view that other central banks will quickly follow the Fed. This could means days, weeks or even months of pressure on share prices. On the other hand, we could see a “v” shaped response – a sharp sell-down and a quick bounce like the post-Brexit markets.

Not everyone is sweating. Investors following a strategic, active approach to current stock market conditions could be cheering, and preparing to take advantage of the sell-off. Whether they sold down holdings, hedged with CFDs or bought put options, any significant falls deliver the opportunity to achieve significantly higher returns than average.

The key question is “what to do now?”

Alert readers will note the selling in Australian shares began three weeks ago. At the close last Friday, the Australia 200 index was already down more than 4% from that level. Sectors such as Utilities, REITs and Energy are off more than 10% in that time. (If investors are “caught”, and remain exposed to shares where a significant move has already occurred, the lower risk approach could involve sitting still).

This lower positioning stands in direct contrast to the US markets, which are selling off from all-time highs. At the recent 5,600 peak the Australian index was still more than 18% below its high tide mark. The situation across the Asia Pacific region is similar. Further selling in anticipation of a faster tightening of US interest rates may not affect all markets equally. There is real potential for local markets to outperform US and European markets.

Additionally, it should be no surprise to anyone that US rates will rise. It’s just about the timing. An adjustment is in train, but this is not the end of the financial world.

Turning to the chart, we can see that recent action changed the picture entirely. This is a weekly chart of the main Australia 200 index. After breaking out of the trading range that prevailed for a year, last week the index failed and dropped back into the range. The action so far this week has is touching a medium term up trend, meaning market moves this week could determine the near term direction.

Monday’s sell down closed near the lows, on higher volumes. This is normally a sign of further selling to come. There is support around 5080, 4990 and 4800, but no-one can say with certainty where the selling will pull up.

Experienced market watchers look for signs of a turnaround in market behaviour. This could take many forms. A v-shape seems unlikely, but can’t be ruled out. A classic turn around would involve “basing” behaviour, followed by a steady move of higher lows and higher highs. Basing behaviour occurs where daily ranges are smaller, and the index repeatedly bounces off (or near) a support level.

In other words, many successful investors will wait for the price action to tell them the selling is over. At the other end of approaches, value investors may see stocks they like at current prices, or may place lowball bids in shares they like. Both approaches can be valid. The important factor is to have a plan, and stick with it through the market noise.

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