We’ve unfortunately had another one of those weeks when the selling becomes indiscriminate and prices seem to run away from us. Fundamentals have been thrown out the window and even stocks that we have identified as being right on support have only held those levels for a day before taking another leg down. I expected the banks to be sold off after the interest rate decision earlier this month, but I didn’t expect our resources to push as low as they have. The Chinese have engineered their economic slowdown and have plenty of tools available to stimulate. We have to remember that Chinese growth is driven by domestic investment, not exports. So extrapolating European problems out to China is a bit simplistic. However, the fact is, fear had taken over for a few days and given our market a pummelling. The severity of the fall at the end of last week has surprised us all. Its what makes me believe that when the market bounces, we should be led by the big miners.
A few other points that are worth noting:
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Last week was the biggest weekly fall on the ASX200 for 9 months (since September 2011 when it then bounced back 7.6% the following week).
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NAB’s fully franked grossed up yield is now sitting at 11.6%.
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Australian 10 Year Bonds are yielding 3.02%, the lowest since the 1940’s. Currently the cash rate is 3.75%, which is normally higher than the long term rate.
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When Lehman Brothers collapsed and the market was at 3145, 10 year bond yields were closer to 4%.
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Lehman’s collapse was a shock. Haven’t we been aware of Greece’s issues for 3 years now?
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As at last Friday, traders were fully pricing in a 25bps cut to the RBA cash rate next month, with a 40% chance of a 50bps cut.
A lot of previously bullish commentators have suddenly turned bearish and are being swept up with the herd. Its too late to be buying defensives and moving to cash. Other people’s emotions are a good indicator of what lay ahead, and the sense of hopelessness seen last Friday is probably an indicator of a bottom for now. Unfortunately most investors are most bearish at the bottom and move to cash, and become most bullish at the top when its too late. The bullishness wasn’t as evident when the market turned a few weeks ago, so that is something we need to reflect on and perhaps see if there were missed signals that we can learn from. But the bearishness is most certainly evident right now. When the market drops this much in such a short space of time, the usual result is a sharp V-shaped recovery. So lets have a look for some precedence.
Below is our market last year during the Japanese earthquake. Our market dropped about 10% over 3 weeks. It was back to the same level 3 weeks later.
Below is a chart from August last year where our market dropped nearly 20% in the space of two weeks. Our market rallied nearly 15% over the next few weeks.
Below is a chart from November last year. Our market dropped about 8% in two weeks. Within the next two weeks we were back at that level.
There are no certainties, only probabilities. So if we assume that a repeat of the previous episodes is most probable, then you will also note that there were two similarities each time. The first one of course is the V-shaped recovery. The second is that the market will slowly come back to retest that low. So that leaves us with the following scenario which I feel can eventuate:
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The market will shortly give us a reversal signal and then rebound in the order of 10% (If you are in cash, that means BUY).
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Having rebounded, the market overall may spend at least a month pulling back to a new low for the year, that is, a level under 4000. So this initial bounce should cause investors to do the following:
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Write covered calls on the stocks we like.
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Sell the stocks we don’t like and get into those that we do. The good stocks at this point will hold up much better than the poor stocks.
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If the market retests this low, it will coincide with a major event (such as Greece defaulting). This will be the “last chance saloon” where you have to take that opportunity to be invested if you aren’t already because the market could possibly trend higher for at least the next few years.
