Pete Wargent blogspot

CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Sunday, 30 October 2016

Is the stock market finally going back to 6000?

Brighter days ahead?

I read an article which suggested that after another two very ordinary years for Australian shares, with improved forecasts for global GDP, resources earnings and EPS, the stars are aligning for Australia's stock market to return to 6000 by the end of next year. 


It's true that stock markets tend to spend more time trending up over time than they do falling, so hopefully this outcome will play out, though for a whole range of reasons, I'm sceptical. 

For one thing, there's rarely much point in listening to stockbroker of fund manager forecasts, for they pretty much always seem to see the market heading higher over the next year or two (and property prices peaking, of course, it's literally the same story every year), even though the ASX 200 (XJO) has actually gone nowhere for a decade, exclusive of dividends.

It should be noted at the outset that you can't really 'forecast' a stock market index accurately.

Since prices are always determined by both demand and supply, unless you've somehow dreamed up with a way to predict both sides of that equation (you haven't), you can't really know with any level of accuracy where the market will finish next year, although I suppose you may be approximately right.

Moreover, forecasting a stock market index can be a fool's errand, for not only do you have to predict what will happen to the economy and in turn company earnings, you also need to assess how investors will reflect these outcomes in stock market valuations, and potentially how market traders will react to these interpretations, and so on.

Degrees of separation?
Behavioural economists have undertaken studies in an attempt to understand this theory. A very simple demonstrative exercise, sometimes held by economics lecturers, is to ask their students to pick a number between 1 and 100 which they believe will be 50 per cent of the value of the average of all the responses in the lecture theatre.
Some people pick numbers higher than 50, which is frankly just worrying. 
Others simply pick the number 50 being the mid-point of 1 and 100 (that sounds like my kind of student, not too much thought or effort expended there!).
Others take this a step further and realise that if others choose 50 then their answer should be 25. Think about this for a moment. If you take these thought processes to their logical conclusion the only rational answer to give is 1. 
In reality, most people never reach this many degrees of second-guessing and the distribution tends to result in the ‘correct’ answer being in the mid-to-high teens.
This is relevant to investment markets, for to some extent this is how investors and traders tend to process their thoughts. They never reach for the logical final answer, in part because we all need returns, but perhaps they will reach a second, third, or fourth degree. Very hard to predict!
The outlook

The main reason that Australian stock markets are at long last forecast to head higher appears to be the recovery in earnings for miners.

Now don't me wrong, I'm probably as excitable as anyone about the recent recovery in commodity prices! It's good news, and overdue at that. 

However, even the most one-eyed of optimists would have to see that the explosion in coal prices is in no way sustainable once China turns the production taps back on.

I don't think I'm being too unrealistic in saying that coal prices could be at least 50 per cent lower by the end of next year. Iron ore prices, while arguably harder to read, could easily see a similar retracement given the glut of supply. 

And that pretty much is the recovery in resources earnings as far as Australia is concerned.

And then there are the banks. 

As noted, it is always very difficult to assess precisely how markets are pricing outcomes, but my own research and liaison tells me that although mortgage arrears are presently very low in aggregate, there is a seething mass of defaults in the post from certain resources regions, which ultimately must impact lenders and mortgage insurers.

Reporting season will show that the banks have continued to deliver very strong returns on equity which currently support valuations, but you sometimes wonder (at least, I do) whether this is akin to a car driving around a racetrack at 300mph. You certainly wouldn't want to have an unexpected blowout in bad debts at such high speeds! 

So that largely accounts for Australia's six largest companies by market capitalisation - four banks and two resources stocks - and close to half a trillion dollars or so of the market's total value, at just under $480 billion. 

And then, property market construction will begin to turn down at some point too, which will impact developers, construction, and materials companies. 

And then if property prices do turn down - one of the stated reasons for shares being a better bet than property in 2017, by the way - there will be a detrimental impact on the wealth effect, and retailers. I could go on...

Inauspicious start

Overall, as a vested interest I'd of course be delighted if the Australian stock market returned to 6,000. But equally I wouldn't be at all surprised to see the market fall next year.

And in any case I certainly wouldn't be basing any investment strategy on a view that relies on higher valuations moving higher the next year. 

Anyway, the market will have the final word. To date, the ASX 200 has declined by 3.7 per cent from October 4 to 5283 at the close on Friday. So we'll just have to wait and see before popping the champagne corks I guess.