Why the outlook for markets has changed

In his market forecast for 2012, Ron Bewley has a stronger sense of positive outcomes in the next 12 months.

With the year less than one month old (at the time of writing), I feel the need to update my 2012 forecast for the ASX 200.

My underlying forecast, as always, is derived from my quantitative interpretation of broker forecasts of company dividends and earnings as compiled by Thomson Reuters Data-stream.

In that sense, I cannot change the number that is my forecast as it is derived from a well-specified set of formulae – but I can, and will, change my risk assessment of my forecasts.

Volatility, as always, dominates market forecasts and last year was pretty bad when it came to market volatility.

On 1 January I posted my 2012 forecasts of 11.3 per cent for capital gains and 16.9 per cent for total returns (ie, including dividends).

My forecast of market volatility is just under 20 per cent. My risk assessment then was that there was limited downside risk but many investors may take some time to heal before they support any potential rally.

It was well known that quarter one was going to be dominated by European bond auctions amid the debt crisis that just wouldn’t go away.

China’s economy was slowing – but was it slowing too quickly and heading for a hard landing? The US had at last started to produce some good economic data – but would it last?

Already this year, the US economic data has added significant support to the strength of its economy – including a best jobs number in four years – and confidence is on the rise.

China posted a gross domestic product read of 8.9 per cent – above expectations – and that largely put paid to those commentators predicting a hard landing.

On top of that, it has been reported that China is ready to relax capital rules for banks to stimulate an economy that is already running at 9 per cent per annum.

The best news so far this year though has been the manner in which the early bond auctions have gone in Europe.

France lost its AAA rating but, as with the US last August, yields fell – not rose – on the downgrade.

Even some of the more fragile economies did much better on yields than in December.

While nothing is certain, the panic over European debt might have peaked – and all that panic has already been priced into the stock market. Of course the European economy will grow slowly at best over coming years – but nothing new there.

Stock markets started the year well. The S&P 500 (to 19 January) had the best start to a year in 25 years – and, at last, the ASX started even better.

The 4 per cent gain on the ASX 200 in the first 13 trading days of the year is over one third of my prediction of 11.3 per cent for the whole year – but there is long way to go.

But what really surprises me are the patterns in the measures I construct to try to better understand the markets – both here and in the US.

I use my fear and disorder indexes to interpret how the market might react to future shocks. My measure of fear is one of excess intra-day volatility in the market.

Disorder is a daily measure of the extent to which the different sectors’ returns are moving together or not.

When fear and disorder are high, I believe overpriced markets fall more quickly than usual, while underpriced markets are more likely to stay underpriced for longer.

I report my daily fear index for the 12 months to 19 January in Chart 1.

The dotted ‘tram lines’ define a range describing where my fear measure resided prior to the GFC for two thirds of the time.

Being largely within the tram lines is, therefore, very good. Occasionally a little outside the tram lines is also normal (34 per cent of the time).

Too much below the lower line could spell complacency. My reading of Chart 1 is that fear has been ‘normal’ since the start of December – and there has been a lot of negative news, particularly in Europe, to digest during that time.

From the start of August to the end of November 2011, the market was extremely fearful – matching some of the data we found during the GFC.

In the first half of 2011, fear was a little high – but there were earthquakes, tsunami, nuclear disasters, floods and cyclones to deal with. In my opinion, this is about the most settled the market has been in 12 months.

While this measure obviously cannot predict what events will bombard the market in the year to come, I do conclude the market is in a much better position to deal with any negative news than it was in the second half of 2011.

My disorder index tells a similar story. If different sectors are signalling disparate returns, there may be more incentive to rebalance portfolios to chase returns – or to get out of the market altogether.

For the last two months disorder has been within or below its tram lines.

That means there have been two months of stability in the market as measured by fear and disorder, giving investors time to regain their sanity and look for opportunities in equities if catalysts present themselves. China, the US and European bond auctions have already provided some positive signals this year.

The Australian data is not as encouraging as some that we are seeing overseas. The two interest rate cuts at the end of 2011 were too late to yet influence employment data.

But with the ANZ bank now having its own monthly decisions on whether it will raise or lower its own rates, the impact of future Reserve Bank moves on rates seems less important. Banks’ borrowing costs do not fall by much when the RBA cuts rates.

I believe China, and now the US, will keep our overall economy in shape, but my ‘model share portfolio optimiser’ told me to get out of consumer discretionary stocks in May 2011 and it is not telling me to get back in.

Parts of the economy will not recover quickly. So, from a macro perspective, OK is my best assessment for Australia until policy changes have some positive impact on the whole economy.

The broking analysts that supply the company-level earnings and dividends forecasts presumably all take macro and company data into account when forming their views of companies’ prospects.

With the next reporting season starting in mid-February, I find it important to follow what analysts are saying in the run-up. I think it would be foolish in the extreme to make a forecast on 

1 January and not revise it as new information comes to hand. Stoically standing by a 1 January forecast makes it a tipping game rather than research with which to form a view of how the market is evolving.

I update my forecasts every day – but for the next 12 months from that day rather than to year-end.

I show the trace of these updated forecasts for the last 12 months to 19 January in Chart 2.

I should stress that my forecasts are solely based on the aforementioned broker forecasts – I add no qualitative overlay.

Importantly, these analysts might not agree with the way in which I interpret these company forecasts – that methodology forms my contribution.

I note from Chart 2 that there has been a strong rally in these forecasts from the October low but, more importantly, the rally continued after the New Year.

My new forecast for a slightly different period (12 months from 19 January) is now 12.3 per cent, 1 per cent above the forecast I made 13 working days before.

While there is some volatility in these day-to-day updates, I do not ignore the 3 percentage point increase in my outlook since the October low.

The final piece in my 2012 market jigsaw is mispricing or exuberance.

Markets are dominated by under and over-pricing as investors try to work out fair value from the price discovery process.

I show my version of mispricing in Chart 3 by sector and for the market as a whole for the end of 2011, and the most recent data at the time of writing.

After months of significant underpricing, even as recently as 30 December, the market was almost fairly priced on 19 January.

My estimate of the fundamental price has fallen over the latter half of 2011, so that the massive underpricing has been eroded both by rising prices and falling fundamentals.

The sectoral view has also been compressed. While resource-related sectors were underpriced by more than 10 per cent at the end of 2011 and the Telco sector was overpriced by about 6 per cent, the range is now much narrower.

The market is poised ready for a reasonably broad-based rally.

After four really bad years on the market – and a terrible last six months – I at last have a stronger sense of something positive in the wind.

None of the problems (US, China, Europe) were unknown in 2008 but I, like many others, didn’t realise how long it would take to sort out these issues.

In a separate piece of work, I looked at really long-run behaviour. I found an amazing result that the average capital gain for the All Ordinaries over 130 years (except for a four-year period) was 5 per cent per annum.

While that result of 5 per cent does not look great, that study suggests – in a long-run sense (not medium-term as with my exuberance measure) – that the market is about 15 per cent underpriced.

It takes on average 18 months for this underpricing to dissipate so that, as it happens, both pieces of research are in broad agreement. Whichever way I slice it, the market seems cheap compared to where it might be at the end of 2012.

Of course, unexpected bad news will occur and impact the market from time to time.

Of course some corrections are a good thing if they are stopping bubbles forming from over-exuberance getting out of hand.

Since I interpret exuberance as being in the danger zone at above +6 per cent, any rapid market rally in January/February of about 8 per cent from 19 January would take us to the +6 per cent overpricing zone – and that bubble would need to correct either by a sideways market movement for an extended period of time or a fall in price back to fair value.

Ron Bewley is the director of Woodhall Investment Research.