Well before the latest Australian share market peak and correction, serious market analysts were predicting a major reversal. So as corrections go this one should not have come as a surprise. It has been widely anticipated and the genuinely smart trading money has been well prepared through strategies like regularly taking profits or setting stop loss levels.
In early July, for example, three weeks before the S&P ASX 200 hit its peak of 6422, high profile AMP Capital head of strategy Shane Oliver was tipping a 15 per cent correction, admittedly some time before the end of 2007. Why this was a possibility, he suggested, was not just because of the mounting US sub-prime loan problems but rather because the share market was now in the third more risky and exciting phase of the current bull market.
Bull markets, according to Oliver, normally experience three phases. The first is the recovery period where investors overcome the excessive pessimism of the bear market they have just left behind. The most recent bear market was the period between March 2002 and March 2003 when the S&P ASX 200 lost just under 30 per cent.
During the initial recovery phase the market gained about 16 per cent in the post-bear year. The second phase, says Oliver is the earnings driven phase where strong profit growth drives share prices higher. There have been three 20-per cent plus per annum years since the recovery year. In all, the S&P ASX 200 has gained around 140 per cent since March 2003.
Interestingly, this only puts it third in the bull market stakes over the last 40 years. It’s well behind the 420 per cent the market gained during 1982-87 and the 325 per cent during the 1974-80 bull run.
Now, according to Oliver, we have entered the third phase, when exuberance can drive share prices faster than profits. The trouble with this phase is that we have possibly seen the first year of it already. During the 2006-07 financial year, the share market delivered a sizzling 30 per cent total return of dividends and capital growth.
That this has been well ahead of profits is likely to be confirmed over the next six weeks during the current company reporting season. A sample of what could be in store was the reaction to mining giant Rio Tinto’s disappointing 14 per cent profit decline.
Oliver says he has been pondering whether we have been in the exuberance phase since the latter part of last year. Even though everyone has been concentrating on the resources sector, industrial shares have been exuberant when compared to their average profit growth of less than five per cent.
Other characteristics of the third bull market phase have been steadily larger corrections. The current predicted correction is up to 15 per cent. Last year’s major correction was a 12 per cent decline. In 2005 there were a couple of 8 per cent corrections. The falls in 2004 were around 4 per cent.
Each correction is bigger than the previous one and this is happening because as the bull market progresses more people enter the market. Nowhere is this more evident than in the various derivatives markets, especially contracts for difference which are a phenomenon of the current bull market. Most of the real growth in CFD activity has occurred during the last three years.
The worry about the CFD growth, says Jonathan Barratt, managing director of Commodity Broking Services is that many traders have limited experience when it comes to dealing with major corrections. The basic strategy that most have employed over the past couple of years – which admittedly has worked well for them – has been buying whenever the market dips. Some actually wait for the market to fall. After Macquarie Bank shares tumbled, for example, there were traders sending in cheques to take virtually immediate leveraged positions.
Suggestions that they might wait to see how the market stgeloped were generally ignored.
Barratt says the current CFD market has many traders who have been relatively recent arrivals who have enjoyed the bull market and seriously entertained ideas of making a living by trading derivatives. They are also traders who if they are severely burnt will probably abandon these ideas. Of every 100 traders who suffer major losses, says Barratt, past experience has been that maybe 30 stick with it.
What traders need is a disciplined way of dealing with a correction, suggests technical trading specialist Larry Lovrencic, executive director of researcher First Pacific Securities. The week before the market peaked, Lovrencic warned that a correction was imminent and cautioned clients of his technical analysis research service against over-confidence. His timely advice for long position holders was raising stop loss levels to lock in profits. His latest opinion was that traders should watch the overall market carefully and only add to long positions once it exceeds the 6400 levels. He warned that while some technical indicators suggested that at just above 6000 the market looks oversold, a distinctly possibility is a fall to the 5600 level.
The problem with bull markets, says Shane Oliver, is the more investors and traders that join in the more people there are who can take fright in each correction. During the 1995-2002 bull market that ultimately saw total share price gains of around 90 per cent, there was one correction in 1997 that saw the US market fall more than 20 per cent. It did however recover to return about 35 per cent for the year.