Just after the world seemed to be settling down – European debt problems were subsiding and US growth was firming – we had everything but the kitchen sink thrown our way in the first quarter.
Q1 was brim full of tragedy: floods, cyclone Yasi, Christchurch earthquake, Egypt, Libya, Japan (earthquake, tsunami and nuclear disaster) and all the rest. But the good thing for investors is – if there can be a good thing among all of this – that our market stood up very well indeed. But we didn’t keep up with the US market over the quarter – falling behind another 2.5 per cent after a 15.3 per cent slippage last year.
All of our indicators are looking very good indeed. Fear and disorder ended the quarter at very low levels. Volatility – measured and predicted – is also at quite low levels. The market was about five per cent underpriced partway through March but pricing was almost back to par by quarter’s end.
When a market is settled, solid growth is more likely to take hold. Had the market reacted badly to such terrible news – as in the GFC or even as in mid-2010 among debt crises, mining taxes and elections – we would be much less optimistic about our future! The market passed Q1 with flying colours.
Last quarter, we predicted about 13 per cent capital growth for the year and we have bedded down two per cent of that total in Q1 – just a little behind but it could have been a lot, lot worse. Our forecasts for the next twelve months – to end-March 2012 – are stronger at 16 per cent. Resources are still the go but financials (excluding property trusts) are staging a comeback.
We think it will take a lot this time around to shake us off our course. At last breaching 5000 points in Q2 – and staying above – seems highly likely (sigh of relief). Once that is achieved, carrying on to 5500 might be a lot easier. But the big comparison is when are we going to catch up with the US and UK markets? We think it is the dollar that is holding us back – and that problem won’t go away anytime soon. But when it does, the sun should shine in a blue, blue sky.
Capital gains forecast
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 slide in broker expectations in Q4 2010 did stabilise going into 2011. But despite the physical and geopolitical turmoil of Q1, broker forecasts strengthened through the February reporting season and beyond. It took the reality of Japan’s nuclear problem to shave a little off the market forecasts. With more than three per cent per annum being added to the forecast during Q1, analysts are expecting a strong 12 months ahead.
Of course global problems still abound. European debt issues will not vanish but the continuing strength in the US economy and the relentless resources rally underpin our market. Even the labour market in the US is getting much better than most expected only six to 12 months ago.
Australia does face some headwinds in terms of carbon taxes, mining taxes and the widening gap between the Greens and Labor in their minority coalition party. With the US market beating the ASX by 15.3 per cent in 2010, we took another 3.4 per cent slip this last quarter. We think the dollar has an awful lot to do with it.
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.
After our market recovered from the impact of the mining tax debate and the general election in mid-2010, our market was about fair-priced for most of October to February. The combined impact of Japan and North Africa/Middle East presented a buying opportunity – for the brave – in mid-March 2011. Of course, when all seems wrong in the world, it is hard to separate out the genuine market dip from a reversal of trend. But to paraphrase Warren Buffet, if we can’t buy when others are fearful, perhaps we shouldn’t be in the market.
It only took a few days for the markets to start yet another charge up – albeit on low volumes. Mispricing has all but been eroded. It appears to us that the market is getting stronger and stronger as the GFC starts to become just a distant memory. The FTSE climbed back to above 6000 at the end of the quarter – about where it was just before the GFC and we were at about the same time! We have lost more than1000 points to the Britons – hard to take.
Along the lines of Q3 and Q4 last year, and the fact that there was only a muted correction in Q1, there may not be many good buying opportunities in Q2 2011. It might be necessary to get in – if you are not already in – at par and wait for our rather healthy expectation of 16 per cent capital gain.
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 be estimated to be 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.
The buying opportunity in March 2011 was spread pretty much across the board but it has been eroded differentially across the sectors. In particular, the strong rallies in energy, materials, healthcare, financials and telecommunications have wiped out easy gains in those sectors.
On the other hand, industrials, consumer discretionary and consumer staples are a little underpriced. The problem with industrials is that it is a sector of two parts – those tied to the resources boom and those that are not. We have a leaning towards the mining services stocks.
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.
Energy jumped out of the box this quarter. Capital gains expectations just about doubled – fuelled by the increase in oil prices and the increasing popularity of LNG following the nuclear disaster in Japan.
The materials sector is now expected to be only an average performer. This sector has done so much in recent quarters that an extra 20 per cent for those in for the ride is quite solid. The industrials sector remains on the podium. Ignoring property – as many are – the other sectors are much of a muchness.
Dividends look really strong in financials and utilities – especially if you are collecting the franking credits in a self-managed super fund.
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 has picked up a little in the last two months but nothing to really worry about.
The increase in volatility during Q1 was not predictable – earthquake and revolts have a way of turning up when they are least expected. Apart from the human tragedy – which is very, very sad – those of us in the markets have to keep going. The one positive for forecasters out of this ‘Quarter of Chaos’ is that it didn’t really do anything to upset the relativities of risk. During the GFC, financials took a disproportionate hit. But – in a separate paper we just published in Money Management – we show that 2011 Q1 was just about the lowest in recorded history for stock returns to move together in harmony.
This harmony in stock returns bodes well for the market – when investors don’t rush round chasing their tails looking for the hot sector (or avoid the disasters) – the market can settle down and grow.
Risk-adjusted sector returns
We combine our 12-month ahead total returns' forecasts 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 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.
It’s neck and neck for energy and industrials in the expected risk-adjusted returns stakes. Even the market looks good with a Sharpe of 1.5. There has been a general improvement in the underperformers but property and IT don’t dazzle.
The materials sector is really starting to lag behind the other two resource-related sectors: energy and industrials. Of course, this does not herald the end of the resources boom – far from it. But with the mining tax not bedded down and some talking of bubbles in commodity prices, caution, as always, should be exercised.
Copper prices – the real bellwether of the commodities boom – have pulled back after a massive run up. Given there was enough bad news in Q1 to upset any investor, the size of the pullback was contained and didn’t signal the end of the run. Perhaps base metals just needed a breather!
Gold peaked in Q1 but, again given the tragedy, gold didn’t really do that much. It seems ‘toppy’.
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.
The materials weight has fallen from last quarter and financials is now a little overweight. Property and IT remain unloved but all of the other sectors are overweight.
In essence, the inter-relations of all of the determining factors are suggesting investors should exercise caution when following the mining sector too closely. There are good pickings around the other sectors.
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 to 2003. The higher dotted level is the GFC level (July 2007 to 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).
The post-GFC regime has almost got back to pre-GFC levels. Even the worst that could be thrown at the market in Q1 2011 hardly got volatility up to the average volatility during the GFC. Indeed, for much of December, January and February it could easily be argued that volatility was below average pre-GFC levels. What is even more remarkable is how quickly volatility dropped after the Japan nuclear crisis.
Despite these ‘facts’ about volatility, many commentators have spoken of high levels. We assume they are referring to the fact that market went up and down a bit during the quarter. We argue that, because the fall and rise was orderly, there was little volatility. Markets never move in straight lines.
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, tend 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.
Given fear in normal times should be above the upper dotted line 17 per cent of the time (and 17 per cent below the lower tram line), we see the market was largely underwhelmed by the impact of floods, cyclones and international disasters. Even the peak for the nuclear disasters was very thin indeed. We believe that when markets are not fearful and expectations for returns are up, bull runs can take hold!
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.
Like fear, disharmony is well down. This behaviour could, in part, be due to more investors trading index ETFs or index-hugging funds. It is harder to outperform when stock returns and sector returns move together. But quite frankly, we would be happy not to beat the index if we could get our expected 16 per cent capital gains plus 4.5 per cent dividends and all in a low-volatility regime.
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 (that is, 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. We revisit last the risks we called last quarter and move forward.
Ignoring the unknown unknowns, some risks were and are on the cards.
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