The market shook off worries about China and the US yesterday and recovered from an early fall to finish up more than 1%.
Overnight, global markets rebounded solidly as well, Wall Street was up, Europe and Asia were stronger and Wednesday’s shudder in China seems to have faded for the time being.
It’s a strong finish to the week and symptomatic of the current sentiment says the AMP’s Dr Shane Oliver.
After undergoing a bout of nervousness from mid June into mid July shares have since surged higher on better than expected economic indicators and a better than expected US profit reporting season.
Further gains look likely.
While we are of the view that the secular or long term picture for US, European and Japanese shares is constrained by high debt levels and the need to reverse policy stimulus the longer term picture is far more positive in emerging markets and Australia.
Also, as we saw in the 1970s in the US or over the last 20 years in Japan a constrained or difficult long term trend doesn’t prevent sharp cyclical rebounds.
This is what we have likely entered now.
Bottoming action
From a purely technical perspective share markets appear to have built a good base over the past nine months.
They fell sharply into November last year on very heavy volumes in the midst of complete panic.
While the bulls attempted a refloat into early January it lacked any conviction with economic data still being poor only to see the bears gain the upper hand again into March.
However, the fall into March didn’t generate any follow through and so when economic data failed to deliver on the feared depression shares took off.
The churning up and down in a wide range late last year and early this year is indicative of past bottoms in share bear markets including that in 2002- 03 in the US.
Since then shares have started to trace out a pattern of higher highs and higher lows.
Additionally, in a bear market shares struggle to break above their trailing 200 day moving average, so the recent decisive break above 200 day moving averages is a positive sign.
A typical cyclical bull market
The typical short term investment cycle lasts around three to five years and looks like that shown in the next chart.
During an economic slump, government bonds are the place to be, but eventually monetary and fiscal stimulus set the scene for the next economic recovery.
Shares normally anticipate this and start to move up about six months before the economy bottoms.
This is the period in the cycle where shares climb the classic “wall of worry” as there is still much uncertainty about whether there will be an economic recovery.
This eventually gives way to a “sweet spot” in the cycle where growth and profit expectations are recovering but inflation and interest rates are still low and stocks are cheap.
This is usually a time when investors are still worried, but it is often the most prosperous time for shares.
After a few years or so, inflation builds and interest rates rise to onerous levels setting the scene for the start of the next cyclical downswing in shares and the economy.
Right now it seems that shares are entering the classic “sweet spot”.
Leading economic indicators are improving virtually everywhere, but because there is so much excess capacity worldwide, inflationary pressures will remain very low.
The next chart shows average inflation in the US, Japan and Europe versus a measure of capacity utilisation averaged across all three regions.
Whenever capacity utilisation is below normal – zero on the right hand side axis – inflation has fallen.
In other words with economic activity having fallen so far worldwide there is plenty of scope for recovery before inflationary pressures kick in.
On top of this, while shares are no longer dirt cheap as they were back in March, they are not expensive either.
Forward price to earnings multiples are around 15 times in the US and Australia which is in line with their long term averages.
However, in Australia if trend earnings are used rather than the depressed level of consensus earnings then on the basis of a 15 times price to earnings multiple fair value for the market is currently around 4600.
And finally, the earnings revision cycle is turning up in most countries as evident in the next chart.
Typically during an economic downturn companies start to factor in the worst and slash costs to compensate, and then when revenues don’t fall as much as feared, profits start to surprise on the upside.
This now appears to be what is happening in the US with 75% of June quarter results surprising on the upside (compared to a norm of about 59%) and the same is likely to occur in Australia with results likely to surprise on the upside over the month ahead.
There is no doubt that the road ahead will be rough.
However, the combination of improving economic indicators, an improving outlook for profits, reasonable valuations, low inflation and low interest rates is very positive for shares and suggests we are entering the sweet spot in the investment cycle.
With cash weightings still well above n
