Again we got ever so close to the 5000 barrier on the ASX 200 (4971 on 11 April) but the US being warned by S&P about their debt ceiling and the Australian dollar put paid to that rally. After reaching a low of 4451 on 20 June (a technical correction), a welcome rally picked us up to close only 230 points down on the quarter.
Technical analysts galore were saying that if we breached 4477 then lower we would go. But we bounced straight back. While we and the US did end the financial year on a reasonably strong rally, most of the problems suppressing our markets haven't gone away. Sure the Greek debt problem got a disguised default/bailout – which the ratings' agencies might still call an official default – but the Middle East / North Africa woes continue (but are largely off the front pages). The debt ceiling deliberations in the US is going down to the wire, our dollar is depressingly high and our non-resource sector faces gale force headwinds – not least of which in retail sales.
But if we take a dispassionate view of the data, things don't seem so bad. We finished the financial year up about 11 per cent including dividends – bang on the average for two years in a row. The market is heavily underpriced and broker forecasts are still optimistic about the future – capital gains of 14.5 per cent for 2011/12. Volatility, fear and disorder are well contained. All we are short of is a bunch of investors who don't think the world is going to end.
Given what we have been through in recent times, any strong rally is likely to bring profit takers out to force a pause in the market. Although many have been waiting for profit downgrades before the August reporting season, they haven't eventuated yet. If we get through reporting season reasonably unscathed, we could end up starting Q4 in a healthy position. Will we breach 5000 in Q3? We should, but recent experience suggests investors will run for cover before that happens. If the market can hang around just below 5000 for a month or two then the breakthrough makes sense.
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.
Capital gains' forecasts slipped a little during Q2 with another one per cent off on the last day of June. At these levels, our conclusion is that earnings' forecasts are strong but many expected downgrades to be signaled by companies before the season opens. If that is the case, then our forecasts will also be revised down.
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.
Underpricing continued to build up during Q2. Of course, the usual suspects of mining taxes, carbon taxes, and the dollar contributed but, now that we analyse US data in the same way that we analyse the ASX 200 in this quarterly, we know that the S&P 500 bounced off the 'magic ' six per cent barrier of overpricing – bringing our market down with it.
The S&P 500 finished the quarter only mildly underpriced but our market continues to display good value for investors. Our market could reach 5000 quickly and only be a couple of percent overpriced. As we will see at the end of this report, fear did rise sufficiently over the Greek bailout deliberations in their parliament that a rapid rise is less likely than a steady gain. But good news in August could soothe our wounds.
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.
While property, telco and utilities were more or less fairly priced at the end of Q2, the same could not be said for the other sectors. In particular, energy, materials and industrials had been really oversold – possibly on fears that China was slowing too quickly. China does not seem to be in trouble so a bounce back in these sectors is quite possible.
Consumer discretionary, on the other hand, is also underpriced by about 10 per cent but this case could be very different. There are strong arguments that internet shopping, the high dollar and the newfound shopper resistance to high retail margins could force a new profit paradigm on this sector. As such, broking analysts may not yet be in a position to identify the new trend and so their forecasts for this sector could be overly optimistic.
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 and materials remain the standout sectors for capital growth and total returns. Materials forecasts are strong but well below those for energy and industrials.
Dividends forecasts for the financials sector underpin otherwise relatively weak total returns forecasts. The same could be said for property but most of the other sectors – other than consumer discretionary – look solid.
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 since then but nothing to really worry about.
With the exception of the IT sector. there has not been much change in sector forecasts of volatility over the quarter. At these levels, sector volatilities are only a little above historical averages and so should not cause any great concern.
However, the relatively low industrials volatility to that for energy and materials makes the industrials growth forecasts in Chart 4 stand out. Our take on this sector is that it is the mining services part of this sector that is the engine for stable expected growth.
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.
The market remains strong with a Sharpe ratio of 1.5 but Industrials is a real standout at over three. Energy, staples and utilities are strong but even property and IT are not overly weak. The strength in utilities has largely come from reduced expected volatility rather than increase in expected returns over the quarter.
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 position in financials has slipped a little from last quarter. Materials remains stuck on the low-side tilt we place on the allocation weights. Property has jumped up from the lower bound last quarter to above market weight this quarter. Much of the reduction in the financials weight over the quarter has gone to property.
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 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. Given the major events that continue to bombard the world economy, it is surprising that volatility did not kick up more. It is doubtful that the Greek debt issues have gone away for long but if new surprises stay away on that front, we expect that volatility will not be as much as a problem in Q3 as it was in Q2.
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.
The fear associated with sorting out the Greek Debt and US deficit ceilings in June has only been surpassed by that caused the Japan nuclear disaster. But fear receded quickly yet again. There was enough fear to make 'cheap markets cheaper' in June but without new shocks, underpricing can be eroded reasonably quickly.
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.
Until the last few days of Q2, disorder remained amazingly low. It seems that index plays continue to dominate the market. No particular sector seems to have caused the recent uptick in disorder – and it is still well below the upper tramline. No cause for concern here.
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:
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.
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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