Where is the Australian sharemarket heading? Are we due for a rally, or is the bear market upon us? And how can investors profit during these volatile times?

Indeed, 2010 has been a volatile ride. After oscillating wildly during the first five months, the Australian market is down a whopping 9 per cent. During May the S&P/ASX 200 Index sunk by around 8 per cent – making it the worst May since 1984.

According to Shane Oliver head of investment strategy with AMP Capital Investors, Australians might have to get used to higher levels of volatility.  Oliver claims that the market’s exposure to new scares, our heavy exposure to the commodities sector, and ongoing aftershocks from the GFC, means market volatility looks here to stay.

Where is the market headed?

Based on consensus earnings growth forecast of 25 percent for the coming 12 months, the market deserves to get back to 5,500 points late in 2010. But this is unlikely to happen as market sentiment continues to drag market returns lower.

Citi equities strategist Richard Schellbach thinks 5,100 points is a more reasonable target for the S&P/ASX200 by year’s end. By the end of 2011 he projects the market sitting between 5,200 and 5,500 points.

Based on Schellbach’s estimates, the current level of actual earnings on Australian equities sits 17 per cent below its trend or mid-cycle level. This supports what he regards as some outstandingly attractive equity valuations.

“Significant earnings downgrade cycles – like the one we have just exited – restore the cost base to a level at which future profit growth is almost assured,” says Schellbach. “The profitability of Australian companies currently reflects healthy margins, not leverage as was the case in 2007.”

Assuming that sharemarket growth projections aren’t adversely impacted by ‘EU contagion’ or further weakness in the US economy, Roger Leaning, head of research at RBS Morgans expects the S&P/ASX200 to finish the year slightly lower at 4,900 points and bounce to around 5,400 points by the end of 2011.

However, he says if intra-month trading ranges swing widely during this period it will make it harder for the market to claw back to 5,500 points.

Despite rallying 6 per cent off lows in recent weeks, he says there’s no guarantee the market won’t dip again by a corresponding or even bigger amount. “Tributary to any recovery will be the removal of market uncertainty inherent within the Gillard Government’s proposed resources super profit tax (RSPT),” Leaning says.

Why ‘buy and trade’ beats ‘buy and hold’

While last year’s more bullish market was all about buy-and-hold, Schellbach says 2010 and 2011 is a time for nimble investors to capitalise on corrections.

To Schellbach that means buying on the dips and locking in gains on the rallies. If, as he suspects, trading ranges are as wide as 15 percent intra-month or 3 per cent intra-day, he argues that there will be no shortage of buy-and-trade opportunities.

Assuming there’s a lot more volatility in store, Oliver says default strategies deployed by investors during the market’s 17-year bull-run – when it was safe to buy-and-hold virtually anything – will be less profitable. Oliver says investors might consider capitalising on opportunities provided by extreme swings in sharemarkets – such as those experienced late in 2008 and early 2009 – over a one-to three-year horizon.

According to Tim Schroeders, fund manager with Pengana Capital, investors who don’t regularly rebalance their investment portfolios within such a volatile market risk missing out on buying opportunities. But investors must find a happy medium between over trading their portfolio and sitting on their hands. “They need to ponder how much of their portfolio should be given over to exploiting market opportunities through a disciplined framework that can consistently maximise returns,” says Schroeders. “That means thinking beyond the mindset that they’ve got just one primary investment pool.”

Over a longer investment horizon, Leaning says a buy-and-hold strategy still adds value. But like Schroeders, he also urges investors to allocate part of their non-core holdings to playing shorter and more volatile swings.

“When the market was at 3,300 points – which put forward PE multiples on Australian equities at around 9 times – a buy-and-hold strategy clearly made more sense than today,” he says.

Nevertheless, he says one way play the current cycle is to sell down or reduce exposure to certain income-bearing stocks that may have lost value over recent months in favour of those offerings greater growth upside. “We advocate investors overlay the technicals over fundamentals, and another strategy is to hedge their portfolio with options,” he says.

Which stocks present the best buying opportunities?

Equities strategist at UBS, David Cassidy says it’s difficult to overlook BHP and RIO considering the size of the discount to their NPV targets of $45 and $90 respectively – especially given the strength underlying commodity demand.

Discretionary retail and domestic cyclicals also on Cassidy’s radar include: JB Hi-Fi (JBH), Harvey Norman (HVN), Incitec (IPL), Orica (ORI), Resmed (RMD) and News Corp (NWS).

Colin Campbell client adviser at Wilson HTM  suspects the greatest value will be gained trading the broad swings – within a potential 700 points range – over six to nine months. He says while the market clearly isn’t going to wait for the All Ords to hit 5,500 points before profit-taking, some investors will fall into the trap of not wanting to get out to avoid paying capital gains tax (CGT).

He too recommends buying on sharp dips, and claims many brokers are waiting for the market to drop to 4,200 points before recommending clients jump back in. “As long as you have the discipline to sell-out, any stock that presents a buying opportunity will do,” reminds Campbell. “Otherwise be prepared to live with low-risk, fully franked blue-chips until the market corrects.”

Campbell says investors looking to ‘macro range-trade’ the market should search for high-beta stocks that will swing-up with the market. And for greater leverage to the cyclical swing he favours: Rio over BHP, JB Hi-Fi or Harvey Norman, and Wesfarmers (WES) over Woolworths (WOW).

Other stocks he says are better leveraged to a big swing include: Macquarie Bank (MBL), Worley Parsons (WOR), Mount Gibson Iron (MGX), Orica, Origin Energy (ORG), Woodside (WPL), Leighton Holdings (LEI), Seek (SEK) and Newcrest (NCM).

Which sectors should investors’ target and avoid?

By playing the resources cycle, Schellbach says investors should receive greater leverage when the market re-rates valuations – currently down an average 20 percent since the controversial RSPT was proposed.

Conversely, he says more defensive-type sectors, notably retail are the ones to steer clear of within the current choppy trading environment.

Overweight sectors within his model portfolio are financials, banks and industrial cyclical stocks that benefit from the economic recovery and improved operating environment. “We are long past the stage when defensives perform and defensives are now set for a moderate or medium term under performance,” says Schellbach.

At the sector level, Leaning agrees that a longer position on resource stocks looks justified, especially with RSPT likely to A) be either diluted, B) already factored-in to current prices or C) off the table completely should Labor lose the federal election. But instead of trying to time relative highs and lows, Leaning says investors who do plan to buy-and-trade on shorter time horizons need a game plan around what constitutes both good entry and exit prices – while avoiding market noise in between.


Other articles in this week’s newsletter

Are we due for a rally, or is the bear market upon us?

18 Share Tips – 28 June

What’s driving the US dollar?

Buying shares on loan? Ways to cover interest payments

Why the average investor achieves sub-standard returns

Trading Strategies And Market Dangers That Hurt Investors

Disbanding The Euro – A Worst-Case Scenario

Top 10 CFD stocks

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