It is surprising how disconnected some economists are from the real world. Some have said the recent Federal Budget will have only a modest impact on the economy. That might be true on paper, but predicting the effect on consumer sentiment is much harder – and vitally important.

I wrote for The Bull last week that “consumer sentiment should weaken in the next few months as higher taxes, levies and tighter welfare-entitlement rules dent confidence”. If anything, I underestimated the effect of the budget on sentiment, judging by recent surveys.

The ANZ/Roy Morgan Weekly Consumer Confidence rating has tumbled since April – when the Federal Government softened the electorate up for the budget. The index is now back at Global Financial Crisis levels in early 2009, despite higher share and property prices.

The Westpac Melbourne Institute index of Consumer Sentiment in April was down 9.6 per cent since November, and surely headed lower when post-budget sentiment is factored in. Talk of a higher, broader Goods and Services Tax, to help the States with education and health funding, could further dent consumer sentiment.

Yes, some of this negative sentiment will reverse as consumers adjust to budget changes. But as I wrote last week, the budget, at the margin, “will add further pressure to an already weak household sector”.  Watch for a run of softer-than-expected economic data in areas such as retail sales over the next few months, and for the official cash rate to remain on hold well into 2015.

I see four key implications for shares investors in the next six months:

1. The risk of a mid-year sharemarket correction is rising

Conditions are ripe for our sharemarket to have a pullback or a 10 per cent correction. US stocks are at record highs and due for a pause. Falls in the iron-ore price are accelerating, recent Chinese economic data has been weaker than expected, and it has become much harder to find value in the local market.

Sharp falls in consumer sentiment further confirm a sub-par economy, and the market has entered the seasonally weak May/June period. A second-quarter rush of Initial Public Offerings and a lifting in takeover activity also signals a hotter market.

Active investors should consider taking profits on stocks that have rallied sharply in the past 12 months. Partly retreating to the sidelines, with a view to buy stocks back when they better value in the second and third quarters, makes sense.

I still see domestic equities having a stronger finish to the year as the housing cycle continues to strengthen and consumers eventually feel more confident, but higher volatility in the next three to six months is likely.

2. Beware high PE stocks that have surged

There is a long list of small and mid-cap stocks trading on nosebleed valuations, as measured by their forecast Price Earnings (PE) ratio. Several star internet, telecommunications and financial services looks ripe for a bigger bout of profit taking as fund managers lift cash allocations in portfolios.  Holding pricey stocks in a pricey market is a recipe for wealth destruction.

The likes of REA Group, Seek, Domino’s Pizza Enterprises, TPG Telecom, iiNet, G8 Education, OzForex,, and Vocation are due for some profit taking. Each is a quality company that should remain on portfolio watchlists, with a view to buy back at lower prices in coming quarter. I’d start with the highest-quality internet stocks, such as REA Group and Seek, before chasing smaller players, during any significant market pullback or correction.

3. Stick with reliable dividend yield

Investors who want to remain fully invested in equities, rather than lift their portfolio cash weighting, should take a more defensive approach and focus on stocks that pay a reliable dividend yield. I’m wary of the usual dividend suspects at current valuations – the big four banks and Telstra – but would prefer buying them to most high PE growth or “momentum” stocks right now.

Conservative income investors should stick to the likes of Commonwealth Bank, ANZ Banking Group, Suncorp Group, APA Group, Insurance Australian Group, Sydney Airport, Woolworths and Wesfarmers. However, there seems little need to chase these stocks higher in the current market.

Some small and mid-cap stocks are interesting yield plays for investors prepared to take slightly higher risk. I continue to favour smaller Australian Real Estate Investment Trusts (A-REITs) such as Shopping Centres Australasia Property Group and BWP Trust, which provides speciality bulky-goods retail space for Bunnings Warehouses.

Listed Investment Companies (LICs) are another interesting source of dividend yield in this market. However, care is needed chasing LICs that trade at a substantial premium to their asset backing. Clime Capital traded at a 4 per cent discount to pre-tax NTA at March 31, 2014, ASX data shows, and looks to be among the better value LICs at current prices.

4. Lift global equities exposure

A key theme in this column in the past 18 months has been to lift portfolio weighting to sharemarkets in developed nations, principally the United States, Japan and, to a lesser extent, in Europe. Those markets offered better value and a falling Australian dollar would boost returns for investors with unhedged currency exposure.

Nothing has changed my view on the need to have higher global equity weighting in portfolios. The Australian dollar, stubborn as it is, has to ease in 2014-15 as commodity prices, led by iron ore, continue to fall and Chinese economic growth slows, and as US interest rates rise in 2015. Global equity market weakness in the next two quarters will be a buying opportunity.

Higher European exposure is the better bet, after the recent rally in US shares. I suggested a higher allocation to Europe in September 2013 in The Bull, and retain that view. The iShares European ETF, mentioned in that article, is up 37 per cent over one year to April 2014.

•    Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their financial adviser before acting on themes in this article. All prices and analysis at May 21, 2014.

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