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Bubble, bubble, toil and trouble

Ron Bewley
22 May 2013

What a difference a day (or two) makes! I started writing this piece on Tuesday 19 February - hence the title. I put all of the charts together on that day but I didn’t have time to write until today – and we ‘kinda’ know the answer now – or do we? What happens next? The charts are updated to the close of Friday the 22nd of February 2013.

I built a measure for market mispricing in about 2004 and developed ‘Version 2.0’ in 2010 when I formed Woodhall. So the results up to 2009 in this piece are reconstructed but the conclusions here are the same as I recall I made in real time. I publish updated results each week on our website. This paper serves to put the whole system in context and gives me more space to discuss what I think is going on now. And by the way, I archive all of the old Woodhall Weekly papers on the website for those who want to check up how I interpreted the results at the time.

Our thesis is straightforward. I believe the best source of information on the stock market’s future is contained in the consensus forecasts of dividends and earnings published by Thomson Reuters. We transform those ‘credible’ forecasts into forecasts of capital gains on the ASX 200 – and its 11 major sectors. If the market runs too hard compared to those forecasts, the market is increasingly overpriced. If the market falls behind those forecasts it is increasing underpriced. The skill in deriving this measure of exuberance is in how the benchmark ‘fundamental’ is constructed. That information is proprietary.

I show the daily history of exuberance measure in Chart 1. When the line is above the solid 0% line, the market is overpriced. Conversely, below that line the market is underpriced. The dotted line indicates 6% overpricing which, since 2005, has been our trigger point for a signal of an imminent correction of 6% - 10% or a prolonged sideways movement of the market. In the latter case, the market might remain at around some fixed level while the market fundamentals improve to erode the mispricing. As such, we do not believe that this measure constitutes a trading rule. Rather, it suggests when it might not be wise to buy and when it might be cheap. Importantly, we supplement this measure with our fear and disorder indexes – also available on our website. We have argued since March 2008 that when the market is fearful, the market can fall faster and stay lower for longer than when it is not fearful.

Chart 1: ASX 200 exuberance since 2002

What I see in Chart 1 is that, in the run-up to the market peak in November 2007, each time exuberance exceeded 6% market reaction was reasonably swift. At those times, fear and disorder were low and so there was not much over-reaction. As fear gripped the market from January 2008 the market did not recover as it previously had done – even though it was cheap by our measure. Our fear index got back to normal in early March 2009 when I ‘rang the bell’ on Switzer TV (Sky Business) to signal that the market was ready to climb back from its low of 3,146.  But the market enthusiasm was, in our opinion, so great that the market rose to 5,000 with major overpricing – and for an extended period. It took the market three years to break that local market high again.

In Chart 2, I show our standard chart which we publish in our Woodhall Weekly. Our market hit 6% on Tuesday, stayed there on Wednesday and got hammered on Thursday. I wrote in our weekly (February 16) that 6% was close but it need not end in tears as it seemed more like a repeat of money rushing in like 2009 than the pre-2007 peak days.

Chart 2: ASX 200 exuberance – last 12 month to the close on 21 February 2013

I think it is important to stress that we compute a comparable measure for each of the 11 major sectors of the ASX 200, as well as for the S&P 500 and its 10 major sectors. I believe the 6% rule seems to work uniformly across these 23 data series. However, markets, and sectors of markets do not necessarily move together. We had the S&P 500 overpriced by only 2.5% when we hit 6% this week and, as the snapshot of sectors of the ASX 200 in Chart 3 shows, there is major overpricing in certain sectors while Materials is actually cheap!

Chart 3: ASX 200 sectoral exuberance

Our argument for quite some time has been that money has been migrating from cash to defensive, high yielding stocks pushing prices to precarious levels. Before yesterday all sectors outside of Energy, Materials and Utilities were overpriced by more than 6%. A correction in those sectors should seem imminent but there are two mitigating factors. First, our fear, disorder and volatility are at low levels even for pre-GFC days. Second, investors who bought for yield are less likely to worry about absolute prices as those investors buying for growth. Interesting, the big sell-off yesterday hit resources harder than the overpriced sectors. Indeed, BHP and RIO fell in price on the open today while the market rallied 60 points before lunch!

In order to separate changes in exuberance due to price movements against changes due to the fundamentals improving, we have an alternative way of showing exuberance in Chart 4 - our Heat Spots map. Instead of drawing the ASX 200 price index as a line chart in the normal fashion we use a dot for each day. This change has minimal impact on data visualisation but when we colour-code the dots we can present a three-dimensional view of the market. We use red for ‘hot’ – when exuberance is more than 6% overpriced, ‘blue’ for cheap and green for priced at ‘par’. We split pricing between par and 6% into black for ‘warm’ and yellow for ‘high’.

Chart 4: ASX 200 heat spot map since 2002

It is hard to see the detail in Chart 4 and so we also present the same chart broken up into different sections by time to emphasise what typically happens when the 6% trigger is pulled. But before we turn to those charts the run-up in 2009 and the subsequent sideways movement is clear in Chart 4.

In Chart 5, it can be seen that the big bull market from the low in March 2003 to the first big correction at the start of 2005. Clearly there was not an immediate reaction as the dots turned red but the market did advance more than 1,000 points – around 30% - without turning red. It could do this because the capital gains forecasts that are central to our exuberance measure were sufficiently strong until the market crossed 3,500 and the rate of growth of capital gains increased.

Chart 5: ASX 200 heat spot map I

In Chart 6 we can see two corrections preceded by just a few red dots followed by a very intense period of red and a bigger correction.

Chart 6: ASX 200 heat spot map II

Chart 7 depicts the run-up to the all-time peak on November 1, 2007. Arguably, there was a lot of money going into super funds under the new ‘million dollar’ rule. Again there seems to have been valuable information at appropriate times uses the exuberance measure. Importantly, in this and preceding charts, there were seemingly ‘buying on the dips’ opportunities.

Chart 7: ASX 200 heat spot map III

Chart 8 highlights the intensity of the overly optimistic rally in late 2009 and the subsequent prolonged sideways movements.

Chart 8: ASX 200 heat spot map IV

Chart 9 takes us up to the close in business on Thursday 21 February. There were but two red dots before Thursday’s correction and that was followed by one yellow dot as exuberance was pulled back to under 4%. With the market up over 60 points at the time of writing on Friday lunchtime, another red dot is not far away!

Chart 9: ASX 200 heat spot map V

So is this a bubble waiting to burst? By our measure it is certainly a bubble but it may not burst for the reasons stated above. It could well be like pricking a balloon though a piece of sticky tape stuck to it. It just deflates slowly and more by sideways market movements as the fundamentals improve following a pretty decent reporting season. We have fair pricing of the market at about 4,800 with an end-of-year target of about 5,200 based on our broker-based forecasting method. We have an alternative long-term pricing model that makes 5,400 a possibility for year end. And how will it get there? Not in a straight line but the market is currently settled and so the future looks not too bad from here.

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