Being an investor in the third quarter felt like an old boxer after having gone a few rounds with Mike Tyson. The fall in the market brought back the horrors of 2008 and, just when things seemed to be getting a little better at the end of August, the market found a new low for the year.
The fundamentals are quite strong. It seems that the end of the world has been priced in. If the world doesn't end, there should be a sharp rally but that might not be for a few months yet. It depends on too many decisions to make an ‘educated’ guess at when we will bottom. There are signs that the market might not suffer any more significant declines but it might ‘bounce along the bottom’ for some time.
One of the big risks is that investors might miss the start of the next rally – being bruised by what has gone on. Investors in cash who wait for signs of life – like returning to the old 4800 to 5000 range – will miss out on the first 20 per cent leg up. For those who are prepared to go the distance, it might be just one more ‘war story’ to tell around the barbeque.
With dividends yield in double figures for the banks, including franking credits and deposit rates starting to fall, there do seem to be good opportunities in the financials sector. If we find out that China has been in total control of its economic destiny, there are massive returns to be had in some mining stocks just to get them back to where they were in April.
Capital gains forecasts
We use broker forecasts of dividends and earnings to construct our forecasts of capital gains and total returns (that is, including dividends) for each major sector of the S&P/ASX 200 and the market.
We construct 12-month-ahead forecasts each day and show the capital gains forecasts in Chart 1 updated for each day for the last 12 months. Of course, each forecast period finishes 12 months after the forecast origin and so the moving nature of the target should be taken into account when analysing this chart.
It is common for broker forecasts to be updated more so during the February and August reporting seasons, when companies typically update their guidance, than at other times.
The August reporting season was solid but the accompanying outlook statements were tainted by the uncertainty caused by the global problems. Accordingly, capital growth forecasts came off by about four percentage points in August but stabilised during September at a little over 10 per cent for the next 12 months. Since average capital growth has been about seven per cent, this forecast is still reasonably optimistic despite the noise in the markets.
Exuberance is an estimate of the degree of over or underpricing in the market or sector relative to our capital-gains forecasts. It is a medium term measure (of up to six to nine months) that we use to try and identify short-term bubbles and buying opportunities.
When exuberance is above the six per cent dotted line, we use it as a potential signal of an imminent six to 10 per cent correction, or an indication that the market may trade sideways until the fundamental has risen to erode any overpricing. It is not designed to be a trading tool. It is a guide for market entry and rebalancing.
The market continues to be underpriced – and by nearly as much as it was during the GFC before the big rally from early March 2009. I took the consensus broker forecasts of 'target price' for each company to produce what is, in effect, an alternative way to compute capital growth forecasts from the method I prefer. Interestingly, these forecasts produce an outcome consistent with our forecast plus our mispricing estimate – an aggregate of about 25 per cent for the next 12 months.
Most analysts and commentators seem to be saying that the market is oversold – pricing in Armageddon – so at some point there will be a strong rally. Given the lack of political leadership around the globe, it is difficult to even make a wild guess of when that rally may start. The problem with strong rallies is those who miss the start and wait for a pullback might end up missing out on some good returns. Buying now might prove to be very profitable but the market is not for the faint-hearted.
We calculate exuberance for each of eleven sectors of the ASX 200 and the aggregate separately. These measures are based on our sector and market capital gains forecasts. It is quite normal for some sectors to have estimates indicating they are overpriced while others are underpriced. Such lack of conformity can be used to aid rebalancing and market entry.
Relative mispricing can be used to stagger market entry by first buying those sectors which appear to be cheap. Similarly, when rebalancing a portfolio, it is possible to first sell in seemingly expensive sectors to generate the cash to buy later in cheaper sectors.
Although the market is very underpriced (by our measure) the mispricing is not uniform across sectors. Indeed, the telco sector is a little overpriced! Two defensive sectors, consumer staples and utilities, are only moderately underpriced.
Sector forecast returns
We believe that it is much easier to predict the returns of an aggregate, like a sector, than an individual company. We use certain statistical methods to ‘clean up’ the company data before it is aggregated into sectors and then the market as a whole.
We know that expected equity volatility is so large compared to expected returns that it would only be by chance that these forecasts turned out to be ‘accurate’. However, the relative sizes of these sectoral forecasts have historically contained very good information and these forecasts underpin our measures of sector exuberance.
The expected returns have changed markedly over the last quarter. Energy, materials and industrials are now more or less level-pegging with around 20 per cent growth expected – excluding dividends. The expected dividends from utilities are necessary to drag its total return forecast into positive territory. Little capital growth is expected in consumer discretionary, financials and property.
Sector volatility forecasts
Sector and market volatilities tend to come in clusters when notable events – such as the sovereign debt crisis – impact the market. Volatility then tends to revert to some mean level. Occasionally, however, the 'mean’ shifts to a new semi-permanent level.
Our forecasting method allows for both clusters and regime shifts. In this way, we hope to react more quickly to new information as it arrives.
At the end of January 2011, we called the end of the financial crisis in that the Financials sector expected volatility was at the low end of pre-GFC levels. Its volatility picked up a little in the first half of 2011 but the turmoil flowing from the European sovereign debt crisis and the political wrangling in the US over deficit reduction has taken all forecast volatilities much higher – with that for Financials now above 20 per cent.
Indeed, there has been a compression of the range for these sectoral forecasts with consequent implications for sectoral allocations.
Risk-adjusted sector returns
We combine our 12-month ahead excess total returns' forecasts over the risk-free rate with our three-month ahead (annualised) volatility forecasts in Chart 6. For this purpose, we are assuming that each sector grows at a constant rate throughout the year.
These risk-adjusted excess returns are often referred to as Sharpe ratios. They are used in our sectoral allocations but, of course, we also need to incorporate forecasts of the correlations between the sectors. The principles of diversification tell us that we should not focus on Sharpe ratios in isolation.
Interestingly, there are marked differences across sectors in these ratios. Only those for Energy and Industrials are reasonably strong. On its own, this part of the analysis would not encourage investment in the market – the market risk does not adequately reward the expected return over the risk free rate. But when this analysis is combined with the underpricing results, a strong case for being in the market could be made.
We combine our sector forecasts of total returns, volatility and correlations between sector returns to form the basis of our sector allocations.
Because we are using three-month-ahead forecasts, these weights would be rebalanced or rotated each quarter. Given our philosophy, such rebalancing would be done in conjunction with sector exuberance.
We, like many others, put limits on how far our optimised sector weights can deviate by the ‘market cap’ weights that form the index.
The outcome is highly dependent upon how these ‘tilts’ are defined. They should reflect the risk tolerance and needs of the investor.
No investor should ever take these recommendations as the basis for forming a view. They do, however, allow investors to keep up with changes in risk, returns and correlations.
Since last quarter, there has been a big shift back to energy and materials and away from financials. Property gets a zero allocation.
In order to support the highly technical forecasting method we use to forecast sector volatility, we monitor market volatility on a daily basis.
We use the same concept of short-term volatility clusters and regime shifts for long-run (mean reverting) levels.
The daily estimates of volatility are described by the yellow line. The lower dotted line is the average long-run level for 1985-2003. The higher dotted level is the GFC level (July 2007-December 2009). The solid black line shows the extent of the post-GFC decline as it is the average post-GFC level (represented by the median).
It is clear from the chart that the US disruptions starting at the end of July, combined with the growing European problems, has taken volatility back up into the high range – but not as bad as it was during the height of the GFC.
Volatility started to return to normal after the US debt downgrade but Europe helped to re-ignite market volatility. It is stating the obvious to say that this isn't a good time to start getting back in the market for those sitting on cash. For those in the market, it might pay to wait and ride this one out – if you can take it.
Our measure of fear is based on a series created in early 2008 to help explain why exuberance measures were not behaving as normal.
The underlying principle is that markets usually go up or down from open to close depending on the sentiment of the day. When the market lurches from one direction to the other during the day, it is a sign of excess volatility, irrational volatility or fear.
We have found that this measure, and our equivalent measure for the US market, tends to lead the ‘VIX’ indexes for Australia and the US.
Importantly for our methodology, we acknowledge that fear exaggerates behaviour. When fear is high, overpriced markets can fall rapidly and underpriced markets can fall or stay down for longer periods of time.
The two dotted lines (or tram lines) in Chart 9 define the range that fear oscillated, pre-GFC, 66 per cent of the time.
Although fear in the US started to rise at the end of July, our measure for Australia did not kick up until the second Tuesday in August – when the market staged a seven per cent recovery from mid-day to finish up for the day to close at just over one per cent. Our market quickly settled – but the US did not. The levels of fear over September were heightened and were conducive to allowing a rally to start.
Disorder measures the extent to which sectoral returns move together on a daily basis. In previous research, we found that increases (decreases) in disorder lead increases (decreases) in market volatility.
If the main ‘play’ is to buy the index, disorder would be very low. When the GFC was at its height, investors were almost panicking in switching sectors such that, at extremes, one sector rose more than five per cent on the same day that another fell by more than five per cent.
The disorder tramlines contained 66 per cent of the observations pre-GFC and so give guidance about what is normal.
After a year in the very low range, disorder has twice burst through the top tramline in August and September. Much of this disharmony can be attributed to the two assumptions (or is it conclusions?) that China will slow down and banks will be affected by the sovereign debt crisis. Our proposition throughout the whole of the GFC was that the market is unlikely to take off when both fear and disorder were above the tramlines. Conditions can change quickly but the end of September was not conducive to confident investing.
The Woodhall Way
We, at Woodhall, have defined a systematic way of analysing the market and taking a position. We also are able to monitor the market on a daily basis. Being systematic does not make anyone right! Indeed, on any given day, the most silly, ill-founded forecast could prove to be the best after the event. We believe that we have more chance of making good decisions if we understand how we made them and, importantly, can learn from mistakes because we can work out what it would have taken to be right!
We do not take any forecast or measure literally – as a certainty. Rather we look at all the statistics in this report and try to work out a common story that links all the analysis. Anyone can cherry-pick and selectively take a position. We also believe that signals sometimes collide and no reasonable forecast can be made. In our opinion, total reliance on formulae (ie a real Quant) is destined for failure. Being able to mesh scientific process with expert opinion has more chance of survival than gut feelings.
The way we read the results in this research note is:
We will monitor our analysis on a daily basis in case the situation changes (it usually does).
There are always so many possible risks that they are too numerous to mention. At Woodhall we feel the need to have a solid base but we are totally aware that ‘stuff’ happens.
Ignoring the unknown unknowns, some risks were and are on the cards:
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
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