ASX 200 (XJO) Update
Friday, 4th December 2020
The interim high for the XJO was set on the 25th of November at 6709 points. Since then the market has fallen with a higher than normal volume accompanying the falls. An average day for volume traded on a Monday is usually around 1bn trades, however Monday saw that rise to an unusual 1.4bn trades. This may be a sign that the “smart” money is hedging their exposure, yet the Volatility index for the XJO has fallen to levels last seen at the start of the year.
When a market becomes blase to the risks associated with equity investing, it is time to be careful. There seems to be a view amongst market participants that everything will be back to normal soon now that the borders are open and there is a vaccine for COVID-19 close by.
It should be noted that markets normally finish bull market rallies on very good news. They don’t finish on bad news. We heard this week that GDP grew at 3.3% for the September quarter and this was trumpeted as the best growth in 44 years.
Treasurer Josh Frydenberg immediately claimed the recession over and that the results were cause for “optimism and hope”.
This is a normal response for any politician as they want voters to be confident in the outlook. However Australia has increased its debt level exponentially and the economy was losing steam before the COVID-19 restrictions hit.
This level of optimism is the key feature of this weeks wrap and we explore how it is affecting all facets of the market, except China.
Optimism is at Historic Levels
Fundamental analysis relies on a series of numbers to make decisions on where the market or a share price should be based on the assumption of “fair value”. This analysis is worthwhile when comparing similar companies within the same sector, but falls short when prices move to levels that are considered expensive.
Therefore to assess how far a market has moved from fair value we can look at various measures of sentiment. These are important when they reach extreme levels, both on the upside (greed) and downside (fear).
We are comfortable with the Price to Earnings (PE) ratio as a tool to determine if the price of a company is ahead of its earnings, but it has its limitations.
A different measure of PE is the CAPE ratio, which is defined as the ratio of inflation adjusted share prices to the 10-year average of real earnings per share. It is a different to the normal Price/ Earnings ratio as it accounts for inflation and looks back over a longer period.
The historical average of the CAPE ratio for US stocks is 17 times. Since 1991, the ratio has been above 17 except for the 10 months after the GFC. However at the moment we can see from the chart below that this ratio has moved to an extreme last seen in 2000 and before that 1928.
Further proof that the market is ignoring the risks of trading in a market when fear is absent is the news from Bloomberg this week that the cost of insuring against a 10% fall in the NASDAQ is at its lowest level since January 2018. Not long after the NASDAQ fell 12% in just 10 days and while there are no guarantees of this repeating itself, caution needs to be applied.
Finally, the chart below, courtesy of CNN Money, brings together 7 measures of “fear & greed” to display what investors are thinking is at any given time. We can use this chart to reinforce the view that the market is trading at historical levels of optimism.
These levels are associated with market tops and the chance of prices continuing higher are falling. The last time the greed factor was this extreme was at the start of this year.
China’s bond market suffered a series of blows during October and November. A string of defaults by state firms has seen confidence evaporate and for the last week of November, just US$660m worth of dollar bond sales sold.
Adding to this lack of confidence, defaults from a state owned coal miner and a leading chip-maker saw yields move higher and sent shivers through the market as there has been a long-held belief that the government would automatically bailout such forms.
This didn’t happen and further announcements from the US government that it may blacklist further Chinese companies due to their military links didn’t help.
If the Chinese bond market were to lose confidence in the government’s ability to manage their debt obligations, it would cause severe effects around the world.
History has shown that the credit markets are always the first to falter. Equity markets are the last to leave the party. When confidence is at historic levels, caution is required.