Weekly Market Analysis: 5000 and beyond?

The ASX200 finished the week at 4936 points, up 56 points or 1.15%. Total move so far this month has been a stunning 3.85%.

The 200 is approaching its mid-April 2010 high (pre “Flash Crash”) after almost a year of trading sideways before The Bernank decided it was time again for commodity traders to buy Maseratis instead of Hyundais. The market is up nearly 15% since the August 2010 lows.

Significantly, it has broken past the psychologically significant 4800 points level after bouncing around support at 4700 points. Volume has been steady since this breakout, but is well down on the initial August 2010 re-flation.

Price action appears to be heading for a small correction in the short term or a small consolidation/sideways action – barring any shock earnings announcements from a blue-chip or two.

Or iron ore prices collapsing.

To 5000 and beyond?

The next significant level is obviously 5000 points. I don’t care what EMH proponents “theorise” – investors, both institutional and “Mum and Dad” place great significance on price anchors, particularly large round numbers. A breakout above this level – in the absence of any mitigating macro factors, including the end of QE2 or the death of the Australian consumer/mortgagee – will most likely develop into a runaway price bubble.

Straight line analysis vs real-world analysis

Having said all that, on tonights ABC News broadcast, Alan Kohler posted an interesting chart suggesting that the current price activity on the ASX200 is “within trend” with the market at or perhaps slightly below value. I’ve re-created the chart below.

This type of analysis is interesting, to say the least. First, it implies that in the medium term share markets generally move within a discernible trend, reflecting the soundness of the underlying economy. Second it implies that you can extend such a line into the short term future proving that the market is fairly priced and not overvalued. Third, it gives ammunition to the punters and brokers (but I repeat myself) that the market has recovered and its all in baby.

In reality, it bears no resemblance to the interaction of stock markets and economies, nor some sort of ability to predict medium term share prices.

Here are 2 examples of straight line analysis and self-reinforcing price behaviour gone awry:

Example 1. From 1995 to mid 2002, the ASX200 doubled, a 10% annualised return, far in excess of nominal GDP growth. The graph below – in log scale – with a single standard deviation line plotted shows how this reflection of economic fundamentals was broken well before the 9/11 tragedy.

The NASDAQ driven tech-bubble burst and suddenly the ASX lost almost 20%, taking almost 2 years – largely helped by a compliant Greenspan – to reach its previous highs before….

Example 2. From 2003 to late 2007, the ASX200 doubled again, this time at over 16% annualised – or more than 2-3 times nominal GDP growth. This commodity led boom saw the ASX200 reach stratospheric heights, but all within a straight line (plotted above at log scale) and indeed within a standard deviation channel – a new “paradigm” – before a sudden collapse brought about by the credit crunch of early 2008.

Finally, let’s plot over a very short time scale, with a very simple linear regression (from March 2009 lows to the end of this week).

More or less. Or More?

Are we witnessing a market trading at or slightly below value? If we except that ca. 4000 points was the regression to the mean after the “it didn’t happen here – it was a Global Financial Crisis”, then the current reflation has almost reached 5000 points, or approx. 25% within 2 years – again implying more than twice nominal GDP growth.

The institutional memory of stock markets rarely extends back more than a generation. It sidesteps the nasty fact that after periods of irrational exuberance as witnessed in the examples above, markets may move sideways – not for months – but years. Within those periods, so-called bear market rallies occur and eventually a new bull market takes shape, the start of which is always called in hindsight.

It took almost 7 years for the All Ordinaries to regain its October 1987 peak with many rallies – and corrections along the way. Beyond drawing a straight line on a chart, the first step to analysing the potential of a new bull stock market is economic growth.

In the post-Volcker “modern monetary” age, economic growth comes from ever-increasing consumption and credit creation, which is then reflected by reflated secondary asset markets acting on confidence that this will continue into the future. Without this confidence and creation of new credit – particularly mortgages, margin lending and securitization, markets will turn Japanese.