Bassanese's Market Insights: ASX at increasing risk of mid-year correction | BetaShares

Bassanese’s Market Insights: ASX at increasing risk of mid-year correction

BY David Bassanese | 5 May 2015
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The Australian share market has enjoyed remarkably good performance in recent months despite the ongoing weakness in the economy, still-high Australian dollar, and the Reserve Bank’s cautious approach to cutting interest rates since February.  It begs the question: can the good times continue?

To my mind, there are growing risks that during the traditionally soft mid-year period there will be a cleansing market correction – which typically produce losses of around 10%. The last two decent corrections, for example, were a 9% decline over September-October last year, and a 10.6% decline over May-Jun 2013.

asx2000

Good performance so far

As seen in the chart set out above, the S&P/ASX 200 leapt around 16% between mid-December 2014 and early March.  Since then, however, the market has struggled to break through the 6000 barrier and has been trapped in a trading range.

Note, moreover, the Australian market was not overly helped by Wall Street, with the S&P 500 index rising by only around 7% over this period.  Instead, our market appears to have taken great encouragement by the shift in RBA thinking toward lowering interest rates further. This has encouraged a further “yield chase” in the local market, with decent income paying stocks – such as financials – remaining in favour.

The market is now overly reliant on low interest rates

The problem for the Australian market, however, is that apart from low interest rates, the other fundamentals of the market have not been especially strong.  As seen in the chart set below, the market has lifted over recent months despite a substantial downgrade in earnings expectations (principally due to falling commodity prices) and an associated fall in the market’s measure of “forward earnings”.  As a result, recent market gains have pushed the price-to-forward earnings ratio to over 16 – or the top end of its range over the past decade.  The market has struggled to rally in recent years with outright valuations this stretched.

asx2

Of course, bond yields today are unusually low – such that the market’s valuation relative to interest rates is still in cheap territory. Specifically, the market’s forward earnings yield (inverse of the price to forward earnings ratio), is around 6.3%, while 10-year bond yields are 2.8% – implying an earnings to bond yield differential of 3.5%, which is comfortably above the longer-run average differential of 2%.  If interest rates stay low – and especially if they move lower – it is indeed possible for the market to rally further, pushing outright PE valuations further above average.

But as with Sydney house prices relative to household income, the further outright share market valuations rise on the back of low interest rates, the greater the risk of a sharper correction later once interest rates eventually rise toward more normal levels.  At least in the case of equities, however, there’s at least a greater chance of a decent upturn in corporate earnings (unlike Sydney rents) once the economy eventually improves.

Over the shorter-term, however, it seems more likely the economy will remain weak – and based on current subdued earnings expectations, forward earnings are not expected to rise by much over the coming year.

Should bond yields rise – either due to Fed policy tightening from mid-year and/or the reluctance of the RBA to rates by enough this year to support the economy (due to property price fears) – the Australian market would be left at great risk of a market correction.   And even if interest rates stay low, moreover, there is a risk of further weakness in corporate earnings which might eventually cause investors to reappraise current high outright equity market valuations.

Either way, the risk of a market correction is greater when the PE ratio is pushing through 16, compared to when it was around 10 in mid-2012

The Bear and Strong Bear Hedge Funds

Investors interested in trying to profit from, or protect against, a declining Australian share market, may be interested to take a look at our Bear (BEAR) and Strong Bear (BBOZ) Hedge Funds.  Both funds seek to generate returns that are negatively correlated to the returns of the Australian share market (as measured by the S&P/ASX 200 index) – with the Strong Bear Fund seeking to generate magnified negatively correlated returns.

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