Global markets are under pressure as a one-two punch of the spectre of higher interest rates combines with the disturbing spectre of war in Europe. As the talk in the financial media turns to that of "corrections" and "bear markets", we ask the question: What are the warning signs an uptrend is coming to an end?
Highlights
- S&P ASX200 technical analysis, including trends and key levels
- Australian stock market valuation trends, and the switch from high-growth to value/cyclicals
- ASX200 sector indices technical analysis trends
- Key technical analysis warning signs an uptrend is coming to an end
- Conclusions for a correction
S&P ASX200 Technical Analysis
The S&P ASX200 chart is an excellent case study for spotting the early warning signs an uptrend is coming to an end. Before we expand, let's first focus on the period before these warning signs, when the trend was intact and strong…
If we look at the period from December 2020 to around mid-September 2021, we can see many of the hallmarks of a well-established and sustainable uptrend. In terms of the price action, we note prolonged periods of higher peaks and higher troughs. With respect to the candles, we note (particularly from April 2020) they tended to be predominantly white, and the number and size of lower shadows tended to outweigh those of upper shadows. With respect to the dynamic support/resistance zones, we note that they were trending higher (i.e., green for short term and dark green for long term), and most importantly, that the price consistently bounced higher out of each zone.
Around mid-September 2021, the price broke below the short term uptrend zone. At the next attempt to reclaim it, the price failed, and instead of the zone offering support, it offered resistance. The zone changed colour from up/green to neutral/orange, and then to down/pink as the price action also transitioned from higher peaks and higher troughs to lower peaks and lower troughs. Also note, larger black candles began to appear. These are all key signals that supply has increased in the market!
And this is kind of the crux of our argument. You can only have an "on the way up" if there is a pervasive excess in demand for stocks over an extended period of time. In turn, this is only likely to occur if the financial and economic conditions are suitable for stocks to look more attractive than alternatives such as cash and bonds on a risk-adjusted basis.
As the attraction of stocks over alternative asset classes fades, so too with the pervasive nature of the excess demand. A couple of things might occur here, either demand (cash trying to purchase shares) may subside, thus now only meeting the supply of shares in the market, or alternatively, demand remains unchained but the supply of shares in the market increases to match the prevailing demand. In either scenario, the market moves closer and closer to an equilibrium scenario, and prices will start to trend sideways.
Sideways trends, of the likes seen from mid-September 2021 to late January 2022, are symptomatic of a market in either a "transitional" or "holding" pattern. If the market returns to a state of excess demand, we are likely to see the previous uptrend re-establish, ergo
holding pattern. However, if the equilibrium in the sideways phase is disturbed with either an unrequited ramp up in the supply of shares, or a diminishment in demand, the
transition in to a downtrend is likely.
Either way, regardless of whether you're an investor or a trader, times get tougher in an equilibrium market. The best thing to do is to pare back risk by not reinvesting profits, and/or refraining from investing new capital unless the technical analysis signals are exemplary (i.e., increase the voracity your minimum entry criteria — only 10 out of 10's will do!). It's sensible during these times to keep one's powder dry for either the potential re-establishment of the uptrend, or the opportunity to buy much, much cheaper should a transition to a downtrend occur.
The deal-breaker for investors should be the transition of the long term uptrend zone (dark green in up, orange in transition, and dark pink in down) from dynamic support to dynamic resistance. This began to occur on the ASX200 around 21 January 2022. This is the first occasion the price closed below the long term uptrend zone since it first established in December 2020.
Investors now needed to watch for signs that excess supply was rearing its head in this zone. Note the candles on 10-11 February and 17-18 February. These are a classic sign of "sell-the-rally" activity. It's important to note here, that a healthy bull market is characterised by pervasive "buy-the-dip" activity. Conversely, in a bear market it's all about sell-the-rally. The two excess supply events in mid-February within the long term trend zone, were strong evidence the market had likely shifted to sell-the-rally.
And here we are today, showing a strong rejection of the long term trend zone, which can now definitively be considered dynamic resistance. There is a very high probability that we have transitioned into a long term downtrend. A close below our expected point of demand 7045 would be very bearish, and a close below 6758 decisive - it will then be a bear market!
Note that the last candle on the chart is live. Ideally, one should wait until the end of the candle to ascertain the technical picture. If the price should close below 7045, then it is a signal that the demand we were expecting at this level has not materialised. More generally, a break of an expected point of demand doesn't mean investors won't continue to seek out risk in the future, simply they will most likely do so at lower prices.
Australian stock market valuation trends
The discussion above explains how we got here from a technical analysis perspective. Let's now have a quick look at how we got here from a macroeconomic, and ultimately, a valuation perspective.
In the table above we show how the average 1-year forward PE ratio for the stocks in various ASX200 Sector Indices have changed since 22 November 2021. Firstly, a PE ratio is perhaps the most widely used and simplest method of understanding the value of a stock. It represents how much you are paying for the earnings of a company. Obviously, you want to pay as little as possible for anything, so when it comes to stocks, a lower PE typically represents better value than a higher PE.
Secondly, we used 22 November 2021 because two very important events occurred which ultimately put us on the path to a potential long term trend transition in global stock markets. The first event was the Nasdaq Composite Index in the USA making its all-time high, and the second event was the reappointment of Jerome Powell as the Chairman of the US Federal Reserve. It is no coincidence that the two occurred on the same day!
Up to his reappointment, Mr Powell had been what markets colloquially refer to as a "dove". This means the market interpreted his comments up to that point as indicating his preference for lower official interest rates. However, practically from his acceptance speech, Mr Powell suddenly turned into a "hawk". That is, his commentary swung to that of preferring higher official interest rates. What an interesting coincidence in timing!
Put simply, stocks that have higher PE ratios prefer lower interest rates. This is because the vast majority of high-PE stocks are rapidly growing businesses, often in the technology, healthcare, or consumer discretionary sectors. Growing businesses often have higher levels of debt than well-established businesses, and as interest rates increase, the costs of servicing this debt can have a disproportionately larger impact on profits compared to the burden it may put upon well-established businesses.
Also, as the earnings of rapidly growing business tend to be skewed towards the future, the higher the official interest rate, the lower the value of those earnings in today's dollars (analysts "discount" future earnings using the interest rate to determine the "present value" of those earnings to investors). Well-established companies already have profits rolling in the doors, and therefore the impact of discounting is less on their earnings.
Finally, as risks appetites wane in uncertain global markets (think record inflation, higher interest, reduced Fed balance sheet, war in Europe!), investors tend to jack-up their discount rates beyond the increase expected from rising official interest rates. This extra portion investors apply to the discount rate is called a "risk premium". For high-growth-high-PE stocks, the addition of a risk premium often means their discount rates are many multiples of well-established companies. In short, the impact of a world that swings from decidedly "risk-on" to "risk-off" can have
significantly magnified impacts on high-growth-high-PE stocks compared to well-established-low-growth-low-PE stocks.
You can read the last sentence of the last paragraph as: It's one of the oldest dances in markets, that is, the switching of capital between "growth" and "value". Growth of course representing high-growth-high-PE stocks, and value representing low-growth-low-PE stocks. There's also another class of stock typically referred to "cyclical". To be fair, the concept of cyclical may also coincide with the concepts of growth and value, but the crux here is that the earnings of cyclical stocks tend to ebb and flow with the economic cycle.
When the global economy is expanding, cyclical stocks' earnings pick up, and vice versa. The key sectors considered to be cyclical stocks likely to benefit from current market conditions are energy and resources stocks. These sectors tend to perform better in a high-inflation-rising-interest-rates environment. Then, combine these conditions with major supply chain shortages for key natural resources, and it’s a tinderbox for higher earnings for these companies in the near future.
In the table above, the tectonic shift in investors' risk appetites between growth vs value/cyclical since 22 November 2021 is stark. Growth sectors such as Information Technology (IT), Healthcare, and Consumer Discretionary have floundered. The starkest shift is most definitely in the IT sector. At 74, the average 1-year forward PE for stocks in the sector was eye watering! Now, it's about half that at just over 36. What we're seeing here is that the market is now only prepared to pay half of what it thought was reasonable for IT stocks compared to just a few months ago.
Compare the slashing of valuations for growth-oriented sectors to the
increase in the average 1-year forward PE ratios for cyclical sectors such as Energy (+3%) and Materials (+10%). Since November, investors' increased their demand for shares of companies in these sectors, pushing their prices higher and their PE's lower. Next best, is a sector long-considered as value, the Financials (-5%). The steady and fat profits of Australian banks is clearly an attractive carrot for skittish investors!
A couple of takeaway points here…Looking at the average 1-year forward PE for the S&PASX200, it has receded from a high of just over 18 in early November to 16. If we look at the 3 years prior to the pandemic, the average 1-year forward PE for the S&PASX200 was approximately 15.7. So, we're very close to what could be considered as "fair value" for the benchmark index.
But, fair value doesn’t mean
cheap! Typically, major market lows have coincided with 1-year forward PE's much lower. At the low of the COVID-induced bear market this key metric got down to 12.7, at the low of the 2008-09 GFC bear market it plunged to just 8.2 (a screaming bargain!), and at the low of the 2001-03 bear market it fell to 13.2. These PE nadirs should give you a great indication of where you might want to put some cash to work if the current bull does swing to bear!
The other takeaway point is: There will be time to buy IT stocks again! At roughly 36, its average 1-year forward PE is still well above the average for the 3 years prior to the pandemic at 26.2. Note however, you can't compare IT's 26.2 to say, the ASX200's 15.7, and therefore conclude tech stocks are too expensive. History shows the market loves paying high multiples for growth, so tech stocks typically command higher PE's than lower growth stocks. So, whilst there's been a great deal of pain (and perhaps there's more still to come), we're at least getting closer to what could be considered as "cheap" in the IT sector.
ASX200 sector indices technical analysis trends
(Note these trends are all taken as of yesterday's close and do not include today's price action because the session is incomplete!)
The upshot of the above discussion regarding the shift in valuations of within the Australian stock market, is the chart above, the technical analysis trends of the major sector indices. Note here the trends represent directly the changes in valuations since 22 November 2021.
The best sectors are the "double greens" of Energy, Financials, Materials, and Utilities. These are the cyclical and value plays on the Australian stock market. Not faring so well, the growth plays from Consumer Discretionary, Healthcare, Information Technology, and Telecommunications — each "double reds".
Our motto is always: Stick with the double greens and avoid the double reds! Note however, this is the best policy when the trend of the overall market is strong. Clearly it's not at the moment…so you may wish to simply sit on your cash until calmer seas prevail!
Key technical analysis warning signs an uptrend is coming to an end
In the image above, we demonstrate the key technical analysis warning signs an uptrend is coming to an end. Firstly, candles — you're going to go from predominantly demand side candles (white/lower shadows) to supply side candles (black/upper shadows). Next, price action — you're going to go from bull market buy-the-dip higher peaks and higher troughs, to bear market sell-the-rally lower peaks and lower troughs. And finally, dynamic support and resistance— you're going to go from double-green supporting prices, through orange and breaching, to double pink and resisting prices.
Conclusions for a correction
In conclusion, hopefully today we provided you with a comprehensive discussion of the current market conditions, but also of how we got here. Further, we also hope we provided you with an insight in to how to protect yourself from future market corrections using the key technical analysis warning signs an uptrend is coming to an end. And finally, we hope we've given you a guide as to the valuations that might prove too attractive to ignore if you're looking to get some cash at work in the event of a crash! Hey — to be forewarned is to be forearmed!
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