The reporting season is in full swing, but the extreme gyrations of the market make it hardly seem to matter. What we may be witnessing is the amplification effect of algorithmic trading, which is likely to occur when anxiety increases and fewer buyers are available. This is of course impossible to know with certainty — although the fact that it is 70% of the activity on the NYSE is at least circumstantial evidence — but there is a faintly suspicious odour to what is going on. Why is the market falling so fast and then recovering so fast? Fear and greed are not usually so fickle. The more usual pattern is a dramatic drop followed by a long period of torpor.
As far as the Australian market is concerned, the geeks have not yet arrived. The order to trade ratio in Australia is about seven to one, compared with averages in America and Europe of 100 to one, with peaks of 250 to one. But we are still affected by what happens in American and European equity markets, and the HFT plague is running riot there. The algos are probably also having an effect on the Australian dollar, which is also swinging wildly. Algorithmic trading accounts for more than half the activity in the foreign exchange markets. This misalignment of time, as I have commented before, is the problem.
Amidst the high tech noise, what is a poor human investor to do? Deutsche Bank is arguing that the market is pricing in zero earnings growth. Mind you, that was Wednesday, a world ago:
• Our analysis suggests that the ASX200 is priced for downgrades of ~15%, which would mean close to zero earnings growth in FY12. This is not our central scenario, and we instead look for downgrades of no more than 7-8% and a PE of 12-12.5x to set our ASX200 forecast of 4550 by year’s end (previously 5100). We forecast the ASX200 to reach 4950 by mid-2012.
• PE ratios have de-rated quite broadly across sectors. Downgrades are deservedly priced for industrials in our view, given the range of headwinds. However, we think the market is pricing too much downside for resources and banks earnings, and thus continue to prefer exposure to these sectors.
If the volatility is algorithm-driven (probably from offshore), the important point is that it has nothing to do with fundamental value. It cannot. The computer programs are not designed to look at the underlying assets at all, only the patterns fo behaviour. Investor sentiment chasing investor sentiment chasing a robot. That leaves fundamental analysis sounding a little wan: Deutsche reckons US equities are cheap:
We see US equities having valuation support at the current juncture. Stocks are yielding 9½%, compared to US 10-year treasuries at around 2½%. Indeed, the gap between the equities earnings yield and the bond yield in the US is the largest it has been for the 30 years for which we have history.
In part that is due to the extremely low cost of debt. But there still is some value, according to Deutsche:
With a market PE of only 10½x, US equities are now trading as cheaply as they were during the financial crisis. The market is also currently the cheapest it has been since the 1991 recession. This implies that investors are pricing in significant earnings downgrades.
That value argument also should apply to Australia. But what is a poor human investor to do?