BCM's Leading Indices

Leading indices are designed to anticipate and identify turning points in the World and Australian economy.

The Leading Index is contained in BCM's composite reports produced quarterly. As well as examining Australia's leading indicators, the report also studies movements co incident and lagging indicators of economic activity in the country, along with comparative data from overseas.

These Leading Indexes, which consist of twenty or more leading indicators, are presented by five typical main Composite Indicators, ie. World Outlook, Australian Outlook, The Growth Sectors, Financial Markets and Domestic Wages and Prices. These include real money supply, stock market price indices, residential building approvals, non-residential building approvals, overtime hours, company profits, real unit labour costs, manufacturing material prices, unemployment rates, Public sector contribution to output growth, terms of trade, net exports, net imports, exchange rates, Balance of Payments, relative strength movement of business sectors, long and short-term interest rates, yield spreads between foreign and domestic interest rates, commodity prices, the lagged impact of output on prices on productivity growth, wages, material, inflation and import prices.

The combination of these individual components is intended to give a more representative picture of the prospects for the domestic economy than any one indicator would by itself. In the past, the typical lead-time was between six to nine months. However, recent observations indicate this lead-time has now shortened to between three to six months.

Implications

Financial Planners and investors need to keep their fingers on the pulse of the economy because it indicates how various types of investments will perform. By tracking economic data such as index of leading indicators, investors will be able to determine the likely path of future economic growth and therefore better understand the economic backdrop for the various markets.

The leading economic indicators are designed to predict turning points in the economy such as recession and recoveries. Despite a few misses, such as during the OPEC oil crisis in the 1970's and the Asian financial crisis of 1997 and 2008 GFC, the leading index has been generally successful in predicting economic turning points, months in advance.

The stock market likes to see healthy economic growth because that translates into higher corporate profits. Rising profits in return leads to higher share prices.

Typically, property also enjoys healthy economic growth. Real estate buyers are more likely to purchase houses and investment properties during times of expansion when jobs are more secure and incomes are growing.

The Bond market, on the other hand, prefers less rapid growth and is extremely sensitive to whether the economy is growing too quickly - and causing potential inflationary pressure. Continued acceleration in the leading index against a backdrop of overheating economy is not good for the Bond market.

BCM draws on macroeconomics regional and insight to company's global industry analysis as summarised below. The aim of this analysis is to identify longer-term themes based on demographic trends plus technological, political and social developments. As well as this thematic analysis, quantitative value/momentum models are used to identify tactical sector opportunities. Both inputs are used in combination to identify sectors to over - or underweight in the portfolio is part of the top down approach is the classic "rotation approach", ie. Mining Stock recovery (value) Vs economic slow down (growth).

• The World Economy

  Description	Country
  GDP Growth	World, US, Japan, Europe, China, India, ASEAN
  Consumer Price Index	World, US, Japan, Europe, China, India, ASEAN
  Core Consumer Price Inflation	US, Japan, Europe
  Unemployment Rate	US, Japan, Europe
  Inflation	India, China
  Consumer Price Inflation	ASEAN
  Monthly Economic Indicator	China
  Credit and Money Supply Growth	China
  Residential Property Market	China
  Industrial Production Growth	China

• Australian GDP Growth and Inflation

  Description	Country
  GDP Growth	Australia
  Underlying Inflation	Australia
  Consumer Price Inflation	Australia
  Tradables and Non-tradables Inflation	Australia

• Australian Outlook

  Graph	Description
  Retail Sales Growth	Values and Volumes
  Private Building Approvals	Total, Houses, Medium-density
  Household Saving Ratio	Per cent of household disposable income
  Consumer Sentiment	Australia
  Household Finances	Debt and Interest Paid
  Dwelling Prices	Australia, Canberra, Sydney, Melbourne, Brisbane, Perth, Adelaide, Regional areas outside capital cities
  Household Wealth and Liabilities	Net worth, Dwellings, Financial assets, Liabilities
  Housing Loan Approvals	Total, Non-first-home buyers, Investors, First-home buyers

• Business Sector

  Graph	Description
  Private Non-Financial Corporation Profits	Mining and Non-mining
  Business Finances	Business credit per cent of nominal GDP and Interest paid per cent of profits
  NAB Business Survey	Business Conditions, Confidence and Capacity utilisation
  Business Investment	Total, Machinery and equipment, Buildings and structure, Intangible fixed assets
  Private Non-residential Building	Work done and Approvals
  Capital Expenditure	Mining and Non-Mining
  Private Engineering Construction Work Done	Total and Mining

• Credit and Money

  Graph	Description
  Credit and Broad Money Growth	Credit and Broad money
  Monetary Aggregates Growth	M3 and Currency
  Credit	Ratio to nominal GDP
  Credit Growth by Sector	Personal, Business, Housing

• Factors of Production and Labour Market

  Graph	Description
  Labour Productivity	Output, Total hours worked, Output per hour worked
  Growth in Labour Input	Total hours worked and Employment
  Factors of Production	Capital stock and Working-age population
  Capital Ratios	Capital-labour ratio and Capital-output ratio
  Labour Force	Participation rate and Unemployment rate
  Wage Price Index Growth	Year-ended and Quarterly
  Employment	Full-time and Part-time
  Job Vacancies and Advertisements	Vacancies and Advertisements

• Regions and Industry

  Graph	Description
  State Share of Output	NSW, Victoria, Queensland, Western Australia, South Australia, Tasmania
  State Unemployment Rates	NSW, Victoria, Queensland, Western Australia, South Australia, Tasmania
  State Final Demand Growth	NSW, Victoria, Queensland, Western Australia, South Australia, Tasmania
  Industry Share of Output	Manufacturing, Property and business services, Retail and wholesale trade, Construction, Mining, Agriculture
  Industry Share of Business Investment	Manufacturing, Property and business services, Retail and wholesale trade, Construction, Mining, Agriculture
  Employment by Industry	Mining, Construction, Retail and wholesale trade, Property and business services, Manufacturing
  Employment Growth by Industry	Health care & social; Accommodation & food services; Retail trade; Mining; Construction; Administrative & Support; Arts & recreation; Financial & insurance; Education & training; Rental; hiring & real estate; Public administration & safety; Professional; scientific & technical; Transport; postal & warehousing; Utilities; Information & telecommunications; Other services; Manufacturing; Wholesale trade and Agriculture, forestry & fishing

• Government

  Graph	Description
  Australian Government Budget Balance	Fiscal balance and Underlying cash balance
  Public Construction Work Done	Total, Engineering, Building
  State Budget Balances	Percent of nominal GDP
  Non-financial Public Sector Net Debt	Non-financial public sector, Australian Government, State and local general government

• Commodity Prices

  Graph	Description
  RBA Index of Commodity Prices	-
  Bulk Commodity Prices	Iron ore and Hard coking Coal
  Commodity Prices	Base metals and Rural
  Terms of Trade	-

• Balance of Payments and External Position

  Graph	Description
  Export and Import Volumes	Exports and Imports
  Composition of Exports	Resources, Services, Manufactures, Rural, Other goods
  Exports by Destination	US, Japan, Europe, China, India, South Korea
  Composition of Imports	Intermediate, Services, Consumption, Capital, Other goods
  Current Account Balance	Trade balance, Net income balance, Current account balance
  Net Foreign Liabilities	Total, Debt, Equity
  Net Capital Inflow	Equity and Debt

• Interest Rates

  Graph	Description
  Australian Cash Rate and 90-Day Bill Yield - Australia	Australia
  Australian Cash RateAustralia	Australia
  Policy Interest Rates	US, Japan, Europe,NZ, UK, Canada, Sweden, Switzerland,China, India, Indonesia, Malaysia, Thailand, South Korea, Taiwan, Brazil, Russia, South Africa, Mexico, Poland
  10-Year Australian Government Bond Yield	Australia
  10-Year Government Bond Yields	US, Germany, Japan
  Spread between Australian 10-Year Bond Yield and the Cash Rate	Australia
  Differential between Australian and US 10-year Government Bond Yields	-
  US Bond Yields	AAA corporates, BBB corporates, Swap, US Government
  US Bond Spreads	AAA corporates, A corporates, BBB corporates
  Emerging Market Bond Yields	Europe, Latin America, Asia
  Emerging Market Bond Spreads	Europe, Latin America, Asia
  Australian Bond Yields	AA corporates, BBB corporates, Swap, Australian Government
  Australian Bond Spreads	AA corporates, A corporates, BBB corporates
  Australian Housing Lending Rates	Bank's indicator rate on new loans, Actual rate on outstanding fees, Cash rate
  Australian Small Business Interest Rates	Weighted-average outstanding variable rate, Overdraft other security, Term loan residential security, Cash rate
  Australian Fixed Interest	Small business, Housing, Swap rate
  Australian Business Lending Rates	Small business and Large business

• Share Markets

  Graph	Description
  Australian and World Share Prices Indices	S&P 500, ASX 200, MSCI World
  Australian Share Price Indices	Resources, Financials, Industries (excluding financials)
  Major Economies Share Price Indices	US, Japan, Europe, UK
  Share Price Indices	World, Emerging Europe, Latin America, China, Emerging Asia
  Trailing P/E Ratios	MSCI World excluding Australia, MSCI Australia
  Forward P/E Ratios	MSCI World, MSCI Australia
  Dividends Yield	MSCI World excluding Australia, MSCI Australia
  Forecast Earnings per Share	Australia

• Bond Issuance

  Graph	Description
  Bonds on Issue in Australia	Australian Government, State governments, Non-government
  Non-government Bond Issuance	Australia and Offshore
  Non-government Bonds on Issue in Australia	Asset-backed securities, Non-financial corporates, Financials, Non-residents
  Non-government Bonds on Issue Offshore	Asset-backed securities, Non-financial corporates, Financials, Non-residents

• Equity Raisings and Business Financing

  Graph	Description
  Australian Equity Raisings	IPOs, Other raisings, Buybacks
  Australian Net Equity Ratings	Financials and Non-financials
  Net Non-Intermediated Capital Raisings	Non-financial corporates, Financials and asset-backed securities
  Business External Funding	Equity, Business credit, Non-intermediated debt

• Exchange Rates

  Graph	Description
  Australian Dollar TWI	Real and Nominal
  Australian Dollar against US Dollar, Euro and Yen	US Dollar per A$, Euro per A$ and Yen per A$
  RBA Official Reserve Assets	Gross, Net, RBA net purchases of foreign exchange
  US Dollar against Euro and Yen	US Dollar per Euro and Yen per US Dollar
  Nominal TWI	US Dollar, Euro and Yen
  Selected Asian Currencies against the US Dollar	South Korea, Singapore, Malaysia, Indonesia, Thailand, India
  Chinese Renminbi	Nominal TWI and Yuan per US Dollar

• Banking Indicators

  Graph	Description
  Bank Profitability	Major banks, Regional banks and Foreign-owned banks operating in Australia
  Bank Profitability	Return on shareholder's equity and Charge for bad and doubtful debts
  Major Bank's Net Interest Margin	Domestic half-yearly
  Bank's Non-performing Assets	Consolidated global operations, per cent of on-balance sheet assets- Impaired assets and Total
  Capital Ratios	Consolidated global operations- Locally incorporated banks and Other ADIs
  Bank's Non-performing Assets	Domestic books- Business and other, Personal, Housing and Total
  Bank Funding	All banks- domestic deposits, short-term debt, long-term debt, equity, securitization

The Concept of Consensus Economic Forecasts

Consensus forecast numbers are usually an average of all economists' forecasts which gives a top down created expectation in general on how the market views the global and domestic prospects.

Financial Planners and investors need to keep their fingers on the pulse of the economy because it indicates how various types of investments will perform. By tracking economic data such as index of leading indicators, investors will be able to determine the likely path of future economic growth and therefore better understand the economic backdrop for the various markets.

The leading economic indicators are designed to predict turning points in the economy such as recession and recoveries. Despite a few misses, such as during the OPEC oil crisis in the 1970's and the Asian financial crisis of 1997, the leading index has been generally successful in predicting economic turning points, months in advance.

The Stock market likes to see healthy economic growth because that translates into higher corporate profits. Rising profits in return leads to higher share prices.

Typically, Property also enjoys healthy economic growth. Real estate buyers are more likely to purchase houses and investment properties during times of expansion when jobs are more secure and incomes are growing.

The Bond market, on the other hand, prefers less rapid growth and is extremely sensitive to whether the economy is growing too quickly - and causing potential inflationary pressure. Continued acceleration in the leading index against a backdrop of overheating economy is not good for the Bond market.

BCM draws on global and domestic macroeconomics as an insight into Fund Managers/Shares industry analysis. The aim of this analysis is to identify longer-term themes based on demographic trends plus technological, political and social developments. As well as this thematic analysis, quantitative value/momentum models are used to identify tactical sector opportunities. Both inputs are used in combination to identify sectors to over - or underweight in the portfolio.

To achieve real-value added profitability of a client's portfolio, some Financial Analysts prefer fundamental analysis of economic data while others have more profit success at technical analysis systems, focusing on trends. Profitable strategies require a selection of tools to determine entry and exit positions and anticipate market behaviour. It may also be obvious that different tools may be applicable for different markets for greater or lesser extent. These profitable strategies may involve a long-term, medium-term or a short-term.

Technical analysis uses both 'top-down' and 'bottom-up' approach except they focus on market data, primary price for criteria used to make judgements. One of the most powerful of the possible technical analysis tools is also one of the simplest "relative strength".

Our source of Leading Indices is BCM's quarterly Leading Indices, which are designed to anticipate and identify turning points in the World and Australian economy.

The Leading Index is contained in BCM's composite reports produced quarterly. As well as examining Australia's leading indicators, the report also studies movements co incident and lagging indicators of economic activity in the country, along with comparative data from overseas.

Finding Good Money in Sector Bets

Sector based investing has emerged as a style that is challenging more traditional approaches such as those focused on regions or the value growth characteristics of companies. As our world globalises, sector investing is growing in popularity. Fund managers/Direct share opportunities are now realising that companies from all over the world that are in the same sector or group of related industries, often perform more similarities than companies based in the same country. This is thought to be particularly true of companies related to industries like technology and energy, whose markets are increasingly global and therefore less affected by country specifics, political or economic factors.

This new way of investing is becoming easier as more stock markets around the world adopt what is known as the Global Industry Classification Standards (G.I.C.S.). Australia's own ASX abolished it's sector categories in favour of GICS in 2002 and eventually more investors around the world will be considering sectors in the same way, improving the quality of information about them and in theory, improving the returns of those who invest in a sector basis.

There are 10 broad sectors under the GICS - Energy, Materials, Industrials, Consumer Discretionary (the things you buy but can't live without), Health Care, Financials, Information Technology, Telecommunication, Services and Utilities. Each sector is then divided up into industry groups and sub-industries. For example, the consumer staples sector is home to 12 of these sub-industries - everything from food and beverage to retail and personal products.

Picking Winners

Investors are increasingly able to access the stockmarket using the sector base style, which sector should they be looking out for. There is a great similarity than ever before in the behaviour of certain sectors across different countries, meaning the 'hot' industries for the Australian FM/DSO in our local market are the ones to watch on a global scale and the industries that our sector conscious managers are warming to, seem to be the ones that were decidedly cold in 2002.

The media industry which falls under the consumer discretionary sector is due to rebound in advertising levels after a period of mediocre performances have rationalised for the better. Resource stocks, the restricting of the Insurance industry with a lot of consolidations post HIH and September 11 2001, considering the re-pricing for risk and more rational price competition.

Going for Growth

The sectors to shine in 2011 will be the growth-type that pummelled last year. The ones that won't will be those that, due to their desirable structure, are already fully priced or those that were over supplied and have spilled over into "stupid competition". Now monopolies are one of the "hot" sectors for 2003 because they've had to rationalise in the sense they hit consumers and help investors. As investor likes industry's high barrier to entry, relative immunity from political disruption and the pricing power of its small number of major players, Food retailing in Australia is concentrated in a few hands - basically Coles, Woolworths.

The second favourite industry is Healthcare, Equipment and Services, which due to the industrialised world's rapidly ageing population, has an obvious demographic advantage. Last year's "safe havens" within the financial sector - banks and resources will be underweight in 2011 due to their recent popularity. Banks, Resources, Energy are another industry that will suffer from too much past good news - hence having very robust returns last year so unless the war lasts and they continue to be in a safe haven, the cycle will probably turn against them. They've almost finished their share buyback programs so they won't be there to prop up their share price.

Yield Curve Points the Way

One of the techniques economists use to predict the direction of the economy and future bond prices is the yield curve. The yield curve offers valuable information for investors regarding the prospects of their investment portfolios, particularly those with exposure to fixed income securities.

A yield curve is simply the relationship between bonds of varying maturities and their corresponding yields. Generally, a plot of the yield curve offers a good estimate of the direction of interest rates in any given economy.

Under normal economic conditions, the longer the maturity of the bond, the higher the yield. This is because investors must be compensated for the 'perceived' higher risk, the longer a particular bond takes to mature. In general, the longer money is invested, the greater the total return.

In the case of bonds, this means the longer the maturity, the higher the yield. Short-term bonds have lower yields to reflect the lower risk of market changes. Although government bonds are considered generally safe and risk free, there were instances where sovereign bonds were subject to default or near-default. Some examples include Russia, which defaulted on its rouble-denominated debt in late 1998, Ecuador, which defaulted on all its Brady and Eurobond debt in September 1999, and Argentina, which suspended payments of its government debt in December 2001.

A higher interest rate (return) is also needed by holders of bonds with longer maturities to compensate for the erosion of the purchasing power of their dollars through inflation.

This is why the direction of the yield curve is also influenced by inflation. Investors will sell longer-dated bonds if inflation expectations rise. Falling bond prices would increase the yield of the long-term bonds, leading to a steeper yield curve. On the other hand, investors will increase their purchases of long bonds if inflation is expected to slow. This will lead to a flattening of the yield curve.

Under normal conditions, a typical yield curve is upward sloping to reflect the relatively higher risk as bond maturity lengthens. The longer the time to maturity, the higher the risk and therefore, the greater the yield (return) required. The slope of the yield curve indicates expectations that the economy will continue to grow at a normal, steady pace with stable inflation going forward.

A flat curve is often followed by an inverted curve, suggesting that lower interest rates and an economic slowdown are on the way. The Australian yield curve displayed a flat (or humped) characteristic back in mid-1987. During that time real GDP was growing strongly, between 4.5% to 6% and investors were betting that monetary policy would be tightened (the reason for the hump) which would, in turn, lead to a slowdown in the economy - reason for lower yields at the longer end of the curve.

The curve eventually inverted and reached its maximum point of inversion in December 1989. An inverted curve portends a decline in economic activity, even a recession. Investors are unwilling to take low rates now because they fear the rates will be even lower in the future. The Australian yield curve in December 1989 predicted the slowdown and eventual recession in the Australian economy in the early 1990s. A steep yield curve signals the beginning of an expansion (usually after a recession).

The yield curve provides an indication of changes in the economic outlook and therefore is a useful barometer of the markets' interest rate expectations. The slope of the yield curve changes depending on investors' expectations of the future.

Australia's current yield curve structure is eerily similar to the one formed in mid-2008, suggesting that an economic slowdown is on the way.

The Interconnectedness Of Sharemarkets - MSCI / GICS

Pigeonholing equities according to artificial boundaries - stock exchanges sectors and geographic locations - is probably not the most sensible way to pick international stocks.

Whether they are value, growth, quantitative or indexed, most international equity managers have one thing in common: the Morgan Stanley Capital International (MSCI) benchmark. Whatever their approach to investing, most managers don't stray far from the country weightings, or indeed sector weightings, which are dictated by this popular benchmark.

But is it sensible to look at companies based on where they are located (i.e. on a stock exchange listing) or even the sector in which they are classified according to the Global Industry Classification Standard (GICS) methodology? Many companies do not fit neatly into one GICS sector. For example, General electric has significant operations covering aircraft engines, finance and white goods manufacturing.

The nature of a company's business can also change significantly, either due to a proactive decision by management or because its sought after product becomes a commodity as new players enter the market. Examples of this are common in the technology sector from domain name licensing to silicon chip manufacture. For a long-term investor, these dynamics command a different approach.

The geographical distribution of investments demanded by an index based approach makes even less sense. The UK equity market represents around 11% of the MSCI, but most of the highly capitalised companies compete in the global marketplace. It is difficult to think of a company which epitomises British tradition as much as British Airways. But the company derives around two thirds of its revenue from offshore operations and has significant exposures to events in countries as far flung as Hong Kong and Iraq. So when an investor buys something approaching index weighting of British Airways, it is gaining a global exposure rather than a British one.

Artificial Boundaries Don't Make Sense When Investing

When judging sportsmen and sportswomen, we tend to rank them as truly great when they stand out on the world stage. Lleyton Hewitt is clearly one of the best male tennis players in Australia, but to be judged truly great, he needs to perform on the world stage. Winning titles like the US open and Wimbledon demonstrate his top ranking in the international arena. So it is with companies.

Judging a company as a standout against its local peers is useful, but if that company's products or services are traded globally, it surely needs to be benchmarked against the global competition. It is fine to be a big fish in a small pond, but if global competitors are in a position to steal your market because of better product or pricing, then clearly your business is vulnerable.

So how can an investor benefit from an investment approach which is not tied to benchmarks or countries? Thematic investing takes just such an approach. It abstracts from the artificial boundaries of the MSCI benchmark to select the best companies globally wherever they may be listed. While benchmarks based on company capitalisation and geographical locations are useful in assessing a fund's relative performance, they should not dictate how its funds are invested.

Capturing Ideas

The thematic investment process starts by capturing everyday observations which point to a theme. Take public/private partnerships for example - everyday observations, such as the budgetary pressure on governments, the massive blackouts in north-eastern USA due to a lack of investment in electricity infrastructure, and the growing need for ageing baby boomers to be able to source predictable returns in retirement. All these observations point to a common theme around the outsourcing of traditionally government-sponsored activities to the private sector. In most cases, the government doesn't want to abandon traditional activities to the private sector in total, but rather take a regulatory role which protects consumers while allowing the private sector to deliver the goods and services.

But you can't invest in themes. That is why once a theme is identified, quantitative and fundamental analysis from research is critical in identifying the best opportunity for gaining exposure to that theme. This involves having knowledge of the global industry in which companies are being sought and, after quantitative sifting, developing a short list of potential candidates.

Only by understanding the sector in total can companies be appropriately ranked in terms of their fit with a particular theme after allowing for valuation differences. Understanding all the major competitors within a sector provides a solid research platform from which the best opportunities can be identified.

So the interaction between equity analysts and the thematic team looks at appropriate stock exposures which can capitalise on the themes identified. A good example of a stock providing exposure to the public and private partnership theme is Autoroutes Du Sud De La France. This is a company which has concessions to build and operate toll roads in southern France until 2030. The government has responsibility for regulating price increases while the private sector delivers the necessary infrastructure and derives a commercial return from it. This fulfils all the needs of the parties involved: the government is providing the infrastructure required while keeping its budget intact. Meanwhile, an investment in the company provides regular and predictable annuity style income for baby boomers in retirement.

Other Themes - Leveraging Off The Technological Revolution

When you talk about technology, most people these days associate it with the tech wreck. If you sift through the wreckage, you can find the odd gem in the tech space - like eBay. It is the purest example of a virtual company we have ever seen.

eBay operates an online auction site bringing buyers and sellers together. Put simply, eBay merely provides its globally recognised brand and some space on its server for people to place their ads. Everything else is outsourced. It carries no inventories, postage is handled externally, and even the design of the ads is done by a specialist company. eBay takes a fee from the sellers to place the ad and gets paid by companies who want to advertise on its site. Operating costs are minimal and the business is totally scalable. In our view, it is almost the perfect business model.

But as former GE boss Jack Welsh noted, most of the ultimate benefits from the technological revolution in the 1990s are likely to accrue to long established companies in traditional businesses who have the nous to leverage the technological advances that were made into making their everyday tasks more efficient. By harnessing the technology available and focussing it on their business problems, these forward thinking companies can steal a march on their competitors.

Tesco is a great example. Boring British supermarket, right? We think about it from a different perspective. Over the last few years, Tesco has used technology to re-engineer its business operations from inventory control systems to checkout counters. Tesco tracks and stocks particular items which are matched to demand at various stores, and it uses consumer buying patterns to map out store layouts and gain efficiencies in its checkout operations. Its massive buying power is leveraged to global supply chains, not just local operations. The execution of this strategy - a relentless pursuit of efficiency through technology - has given Tesco a sustainable competitive advantage over its competitors. For investors, this translates into sustainably higher profits and a re-rating by the market.

The key to both these examples is that they are not one- to two-year stories. They are strategies which play out over a decade. The thematic style of investing allows this to be factored into the rationale for holding a stock, with the bulk of benefits often delivered many years after the initial purchase was made. It doesn't mean you ignore valuation, but it shouldn't be the sole reason you hold a stock in the portfolio.

Shortcomings Of A Short-Term Valuation Approach

We know that markets are inefficient in pricing stocks when using current information. This is even more the case when it comes to recognising which companies will benefit from the emerging trends over the next decade and beyond. Fundamental research can assist in identifying companies with the greatest potential over this time frame, but another important part of stock selection revolves around identifying asymmetries.

Research analysts can't predict the future price of any stock with certainty, but they can put a fair value on a stock and bands around that which tend to indicate whether it is more likely to appreciate from current prices or fall. Technically, because of the short time horizon used by many managers, these valuations cannot capture the full upside potential which a stock may possess as global dynamics evolve.

A thematic approach, on the other hand, allows a longer-term perspective, which may present opportunities for further upside potential as long as the holding period is long enough.

We have identified four sources of asymmetry:

1. Investment time horizon. For a typical FM/DSO, this is relatively short, between one to two years. The pressure from monthly investment surveys can often compress this time line even further.
2. The prevalence of a benchmark mentality in the approach to investing. This manifests itself in small deviations from benchmark weightings and trend following behaviour within the fund management community.
3. Regulatory distortions within an industry or country which a globalized industry will find hard to maintain (e.g. Japan).
4. Complexity of the industry and the analysis required to adequately understand a company's potential value.

Diversification Still Critical

The goal of the thematic approach is to identify the upside potential of well-positioned and undervalued stocks and benefit from their re-rating. But like any good fund manager, the thematic process needs to allow for diversification to mitigate potential risk.

Putting It Together

Profitable strategies require a selection of tools to determine entry and exit positions and anticipate market behaviour. It may also be obvious that different tools may be applicable for different markets for greater or lesser extent but too many tools and ranges of application may cause some confusion.

These profitable strategies may involve a long term, medium term or short term. A sensible approach may be the first determined by the type of profitability that is applicable given the individual circumstances such as the client's financial position or funds under management, age or life expectancy, risk tolerance and level of investment knowledge.

Long Term

A high probability exists that during the passage of the economic cycle, most markets will experience a period that produces a long-term rise or fall. For example, a bull market for shares almost always occurs during a recovery period that follows a recession. If the domestic and international shares were to be the investment vehicle, it would be appropriate to examine their respective long-term history such as the ASX All Ordinaries or ASX 200 and the Morgan Stanley Capital Index. Such analysis would determine the position of price action in relation to major support levels.

The Financial Planner may decide whether the client has sufficient tolerance to absorb the falls or retracement that occurs during a bull market. A perusal of past history will reveal the highest extent of retracement likely and this may determine the capital used.

For example, from 1983 to 1987, the All Ordinaries rose from the vicinity of 500 points to 2300 points. This rise of 1800 points meant that the largest retractable fall was 200 points or 15% and this occurred when the index was 1300 points. The effect on the account should not reflect this movement as the Financial Planner should opt to maintain a Stop Loss - meaning cutting losses early.

In other words, it's a natural fact of human nature to hope for the best and think no mistake has been made if a loosing position is not closed out. But if the market continues to fall sufficiently before reversing, there's every possibility that the client will not be aboard for the rewards. The greater the loss becomes, the more reluctant the Financial Planner to close out the position.

If the "Stop Loss" had closed the position, the outcome would have been evident - the Financial Planner having stayed out of the market until the retracement had completed - re-entry would occur when the price action reversed.

Medium Term

A medium term Financial Planner generally holds a position rising parameters that will maintain that position for a period of one day to several weeks.

Short Term

Short term involves closing and opening positions before the close of the day's trading or entering or existing several times a day.

Intra day trading generally requires access to live data to manage multiple clients' portfolios. The cost of this data and the supporting hardware are costs that can only benefit our clients. For example, imagine a major fall on Wall Street overnight. Market action is activated entry exit at specific targets. Financial Planners may close out positions overnight yet still open at the end of the trading day. Closure of selective positions eliminates the effect of any movement that may occur overnight. The result is much tighter control of capital.

Select the Market

The Financial Planner should give some consideration of the general economic environment and possible strength and direction of overseas markets which may have some influence on the local markets.

Is the Market Trending or Non Trending

The selection of tools may vary depending upon whether the market is moving sideways or trending strongly. The trading of non-trending markets may use techniques such as breakaway from support and resistance, channel and oscillator indicators.

The support tools may be a combination of moving averages D.I.M. (Directional Movement Index) to determine direction of the R.S.I. (Relative Strength Index) and Stochastic Indicators to identify the over-bought and over-sold conditions.

If the Market is Trending, Determine the Trend

It is usual to accept the established trend during the previous 200 to 250 trading days as the dominant trend. This represents approximately one calendar year of trading activity. The determination of trend follows the construction of a trend line or using a 200 period moving average.

The medium-term trend may cover a true period of 21 to 80 trading periods. In calendar time, this is a period of one month to four months.

The short-term trend may cover three days to one month. The safest decision is one made when the three trends are in sympathy. Any trend though can only persist for a finite period of time. The longer the trend has continued, the lower the probability becomes of that trend continuing. The more appropriate though may be for the short-term and medium-term trend to be in the same direction in adolescence of a new major trend.

The long running bear market may be approaching a major long-term support level. This situation may not provide a high probability of success for a short position even though the short position is in sympathy with all three trends.

Choosing The Strongest Fund Manager/Stock In The Strongest Sectors Boosts Your Chances Of Success

Unless we are adopting a "passive index" approach, all investments and tracking methods involve trying to find outstanding shares.

In the investment world, there are two basic approaches to finding the best shares. In the professional analysts-speak, these are known by the jargon terms "bottom-up" and "top-down".

The "Bottom-Up" Approach

Is known simply as "stock picking". Analysts who employ this method, look at the entire universe of shares and try to find the best ones by applying various tests. There is a wide range of possible tests that may be used, based on accounting data, market price data and subjective judgements like quality of management.

The "Top-Down" Approach

Is the search for the strongest fund managers/shares on the logical grouping they belong to. Assuming that analysts tend to look anywhere in the world, they will compare all the available national markets and select the best ones. Then they take only the best markets compared to all industry sectors within them and select the best ones. Finally, they take only the best sector, compare all fund managers/shares within them and select the best ones. Again, there is a wide range of possible criteria that may be used to access which are the best.

Relative Strength Index

Technical analysts use both top-down and bottom-up approaches except they focus only on market data, primary price for the criteria used to make the judgements. One of the most powerful of the possible technical analysis tool is also one of the simplest - "relative strength".

Relative strength is simply one thing compared to another to see which is increasing the price faster. To do this, the comparisons must have a common base so if we divide the prices over the time of the listed fund managers/shares by a common base such as the market price index, we will be able to identify which fund managers/shares price are rising the fastest.

We are not restricted to fund managers/shares; we can also use the first indexes of industry sectors to find the sectors that are the strongest compared with the overall market by dividing each sector index by the general market index. We could also do this for national markets compared with a world index.

Analysts have found that the strongest fund managers/shares or sectors tend to remain the strongest in their field for some time. If we can find the strongest portfolio synergy and stay with them while they are performing better than the market overall, we should have a superior outcome. This has an advantage over the fundamental analysts who might identify what is thought to be the great fund managers/shares based on its prospects and management but the market hasn't recognised yet. The technical analyst is therefore looking to add the timing dimension.

Relative strength analysis can be done a few different ways. It can be done by hand using the Share tables section and a calculator. The computer literate reader could use a spreadsheet. Technical analysts would use their charting software but these methods will vary slightly depending upon the features built into each charting software. We could simply chart the relative strength of every industry sector and usually inspect the charts to find which has risen fastest in recent times.

However, we can hone in on them faster if we shift them mathematically. I want to find the sectors that have gone up the most in the last three months. To do this, we take the price now and divide it by the price three months ago. This will indicate which sectors are rising in price and by what percentage. We then select the ones with the strongest percentage. If a three ninth relative strength sector produces too many sectors on the rise, then narrow the field down, either 44 or 22 trading days, sample, instead of 66 days or three months, sample, so as to make a valid comparison.

Therefore, having found a relative strong sector or stock over a specific period, the next step will be to do our research and to see whether it will fit into the portfolio.

Market Analysts Would Agree that Equities are a very Risky Asset Class

Traditional managers are generally handcuffed to benchmarks and therefore find it difficult to manage volatility, and as a result, they simply run their portfolios with a similar volatility profile to the index that they are benchmarked against. Unfortunately, it seems to be acceptable for traditional managers to lose money as long as the index they are benchmarked against loses a greater amount than the manager. If they lose slightly less than the index, then the traditional manager feels he has added value. Such an outcome could be a sub-optimal result for the absolute return for the financial planner whose goal is first to preserve capital followed by pursuit of profits.

Traditional Fund Managers generally put too much emphasis on the continually rising market theory and negative returns would be seen as a good result if the manager had out-performed the index they were benchmarked against, whereas Financial Planners consider capital preservation of client portfolios is paramount and any loss is under-performance.

Fund Managers believe that if you just stick with the market then you will be OK in the long run; for example, for the period 1964 to 1981, the Dow Jones Index was without increase with periodical ups and downs, thus remained gainless but to a retiree this meant no capital growth. Risk assessed very differently by Financial Planners will define risk as a deviation from the benchmark as a permanent loss of capital.

What History of the Bear Market teaches us

Following the crash of 1929, the bear market was a slow motion featuring no fewer than six major rallies from 1930 to 1932, each one peaking lower than the previous one but the worst was to come; the Dow Jones Index virtually went sideways for some 20 years before the post war boom kicked in, in 1950 and lasted until the mid 1960's. So bear markets come in two varieties:

• Short - two to three years characterised by sharp rallies and steeper falls, ie. 1973 to 1975
• Long Cycles in market stocks take two steps forward and three steps back for up to 2 decades, ie. 1966 to 1982

A very long bull market can be followed by another market of almost equal duration, ie. 1982-2000 suggesting punishment could go on for 10 years. What is clear is that stock prices have got to go a long way before they met the single digit multiples P/E's of previous bear markets.

Understanding Timing can bring value

Should asset allocation be the same in high and low inflation environments or whether markets are at peaks or troughs. Planners must exercise judgement; it's unavoidable even by those who use diversified funds.

• Rationality believes because we spread a client's money over the typical Balance type mix, we have achieved proper diversification and sit back and waited for the rewards. Equity performances are more than just an average return and standard deviation; they are about people, investors and short-term disappointments.
• Avoid International equities when the value of the Australian dollar is rising and International Securities are falling because:
  1. Both in terms of conversion and exchange rate risk, ie. purchase in offshore currency and convert to local currency. In other words, the offshore investment has to risk 3% to 4% just to breakeven.
  2. Similarly, their poor relative performance in recent years, making the same mistake made 10 years ago when they decided to enter the foreign markets.
• If growth funds are selected, the Financial Planners have chosen a fundamentally stock market based allocation. As we have found out in the latest global stock market debacle, Fund Managers only play at the edges around their central asset mix mandate.
• As a good example of share prices trading at a higher price relative to R.O.E. to justify it, Japan stock market outperformed the rest of the world pre '89 for a good 15 years which provided a compelling reason not to invest overseas which investors tended to ignore. These out performances left Japan markets trading pretty rich values, leaving Japan shares trading 5 times book values which normally should have been 2 times. The same similarity applies to the US share markets in the '90's but not as badly overpriced like Japan's was.

Applied Risk Management to Difficult Economic Environment

The guidelines contain a series of applied risk management tips, designed in a systematic approach that leaves nothing to chance when it comes to building a superior practice to build trust to deliver the value to clients

A. The things that the GFC have been the big issues

There are several key things about markets today, which have caused an explosion in risk premiums that have long-term implications.

1. We saw a substantial cut in interest rates by central banks such as the US Federal Reserve Bank cut interest rates to a 40 year low.
2. If you are looking for a closer historical comparison for today's market, points towards Japan in the 1980's compared to the US in the 1990's. The difference is the US is taking stronger steps to head off the deflationary threat, including bringing forward tax cuts and the likelihood of the US Federal Reserve budget will return to deficits to re-flate the economy.
3. We can expect sharp rallies in the US market but the overall progress will be muted because the bond yields will move up quickly to effectively cap the limit.
4. It's important to remember embedded in the high returns out of the equity markets through the 1990's markets was an expansion of price earnings driven by inflation falling. Clearly, returns going forward are not going to be as spectacular as we had in the 1990's.
5. One way to think about the equity market returns is that you get a dividend yield, earnings per share growth and a price earnings multiple expansion or contraction. Through the 1990's we had all three working in a significant, positive way and that won't be there in the coming decade so it will very much be driven by company earnings.
6. Be on the look out for being overexposed to regional global sharemarkets and residential property, showing all the aerodynamic traits of a house brick.

B. Investors in Shellshock Dimension

1. For many people, their goal of an early retirement has taken on a mirage-like quality.
2. People in retirement have seen their precious capital dwindle alarmingly.
3. Investors find themselves in "Catch 22". Do they put their money into markets that destroyed value last year and still look nervous with the prospects of war in Iraq or do they jump into the hottest of hottest of property booms and be prepared to ride out any price falls. Or do they sit on their hands, keep the cash in the bank and wait for the market to settle down.
4. Lower returns, higher risk and more volatility are all the regrettable part of the landscape. Investors will have to accept going forward as painful as it has been in 2002 and is looking like a massive reality check, particularly for people who have just retired or hoping for an early retirement, ie. due to a large number of retirees investing through Allocated Pension which have exposure to balance funds with around 65% exposure to growth assets, will be a bad year.

Allocated Pensions have served them well but because people have had to draw down capital over the last couple of years, they are questioning whether they are in the right product. This is a good discussion to have with a Financial Planner but it comes down to your investment horizon - is it 2 years or 15 years?

There are two types of investors - those who have already invested and those who are wanting to get into the market. Trying to pick the right time to enter the market is more difficult because of the market volatility so it's really about dollar cost averaging.

Some investors are playing the 'blame' game when it comes to allocated pensions. They are looking at allocated pensions, seeing the balance going down and blaming the product rather than what is happening with investment markets. What people need to do is concentrate on how they set it up, how they chose the underlying investment, how they blended the various Fund Managers together with what levels of income they choose.

In many ways, investors are living in fools paradise as a result of Financial Planners who introduce them into allocated pensions at a time when equity markets were performing really well and you were able to get your account balance growing while drawing down an income. Clearly, there is a difference between people who have had an allocated pension for some years and someone looking at establishing one today.

However, it's causing people to re-examine allocated pensions in an understanding they serve both as a long term investment with a significant amount of growth asset yet at the same time, have sufficient income earning assets to meet the cash and future income needs for a time horizon for five years. This sleep factor is part of an inbuilt safety factor approach for an unforeseen fall in levels of returns from underlying Balance funds coming off the 1990's of between 12 to 15 per cent pa., to an expected forecast of between 5 to 7 per cent pa. return for the next decade.

C. Today therefore is to concentrate on building a portfolio that generates income

Markets are already factoring in interest rates are bottoming out and will go up which therefore many pundits believe equity return will range between 8 to 12 per cent pa., with sharp volatility over the next 5 years is the sort of market that won't support rising share prices.

A lot of people think you can't go wrong with equities and for the past 20 years, they have been right but now people need to reassess their risk tolerances and make sure they have an appropriate minimum and maximum risk exposure to various types of assets and that they use opportunities to swing between various asset classes.

D. Low Returns and Lifestyle Bottom Line

Lower returns over the long term mean one thing for most people - less to retire on.

There is a clear message that people will need to save more or leverage what they have got. There is a growing realisation among a lot of people that they won't have enough money to retire on to support their lifestyle. People in super funds might need to consider internally geared share funds or other strategies like salary sacrifice, work longer or even a career change because if they don't, they won't get to their target. The challenge is if people think they are going to retire at 55 or 60, you will need an enormous sum of money.

E. Property Facing Shakeout

Property - that great repository of wealth was the one bright star in an otherwise gloomy investment landscape.

Although the fundamental variables that have pushed the prices up have not significantly changed such as low interest rates, high income levels and easy credit, remain in favour of residential property markets, however, there has been a great deal of negative sentiment by the mass media, lending institutions, Reserve bank and the Prime Minister stating that recent increases are unsustainable.

The stock market and technology boom and collapse is a recent reminder that in the longer term, the market tends to revert back to rational behaviour. Unfortunately most of the population believes that house prices don't fall but instead in the worst situation remain flat. Well, in the two-year period from December 1988 to December 1990, residential real estate fell across the board 30% and then remained pretty flat for the next 5 years.

It is certainly possible that a greater magnitude than the 1988 cycle could happen given, on average, Australians are now carrying twice as much debt as they did in 1988 and the fact that the 47% activity of investment properties compared to the 1% of owner occupier lending ratio, has been responsible for fuelling the dramatic price increases.

There is no doubt that we are in a vicarious position with the whole economy riding on the housing boom.

Determining The Trend

Profitable strategies require a selection of tools to determine entry and exit positions and anticipate market behaviour. It may also be obvious that different tools may be applicable for different markets for greater or lesser extent but too many tools and ranges of application may cause some confusion.

These profitable strategies may involve a long term, medium term or short term. A sensible approach may be the first determined by the type of profitability that is applicable given the individual circumstances such as the client's financial position or funds under management, age or life expectancy, risk tolerance and level of investment knowledge.

Long Term

A high probability exists that during the passage of the economic cycle, most markets will experience a period that produces a long-term rise or fall. For example, a bull market for shares almost always occurs during a recovery period that follows a recession. If the domestic and international shares were to be the investment vehicle, it would be appropriate to examine their respective long-term history such as the ASX All Ordinaries or ASX 200 and the Morgan Stanley Capital Index. Such analysis would determine the position of price action in relation to major support levels.

The Financial Planner may decide whether the client has sufficient tolerance to absorb the falls or retracement that occurs during a bull market. A perusal of past history will reveal the highest extent of retracement likely and this may determine the capital used.

For example, from 1983 to 1987, the All Ordinaries rose from the vicinity of 500 points to 2300 points. This rise of 1800 points meant that the largest retractable fall was 200 points or 15% and this occurred when the index was 1300 points. The effect on the account should not reflect this movement as the Financial Planner should opt to maintain a Stop Loss - meaning cutting losses early.

In other words, it's a natural fact of human nature to hope for the best and think no mistake has been made if a loosing position is not closed out. But if the market continues to fall sufficiently before reversing, there's every possibility that the client will not be aboard for the rewards. The greater the loss becomes, the more reluctant the Financial Planner to close out the position.

If the "Stop Loss" had closed the position, the outcome would have been evident - the Financial Planner having stayed out of the market until the retracement had completed - re-entry would occur when the price action reversed.

Medium Term

A medium term Financial Planner generally holds a position rising parameters that will maintain that position for a period of one day to several weeks.

Short Term

Short term involves closing and opening positions before the close of the day's trading or entering or existing several times a day.

Intra day trading generally requires access to live data to manage multiple clients' portfolios. The cost of this data and the supporting hardware are costs that can only benefit our clients. For example, imagine a major fall on Wall Street overnight. Market action is activated entry exit at specific targets. Financial Planners may close out positions overnight yet still open at the end of the trading day. Closure of selective positions eliminates the effect of any movement that may occur overnight. The result is much tighter control of capital.

Select the Market

The Financial Planner should give some consideration of the general economic environment and possible strength and direction of overseas markets which may have some influence on the local markets.

Is the Market Trending or Non Trending

The selection of tools may vary depending upon whether the market is moving sideways or trending strongly. The trading of non-trending markets may use techniques such as breakaway from support and resistance, channel and oscillator indicators.

The support tools may be a combination of moving averages D.I.M. (Directional Movement Index) to determine direction of the R.S.I. (Relative Strength Index) and Stochastic Indicators to identify the over-bought and over-sold conditions.

If the Market is Trending, Determine the Trend

It is usual to accept the established trend during the previous 200 to 250 trading days as the dominant trend. This represents approximately one calendar year of trading activity. The determination of trend follows the construction of a trend line or using a 200 period moving average.

The medium-term trend may cover a true period of 21 to 80 trading periods. In calendar time, this is a period of one month to four months.

The short-term trend may cover three days to one month. The safest decision is one made when the three trends are in sympathy. Any trend though can only persist for a finite period of time. The longer the trend has continued, the lower the probability becomes of that trend continuing. The more appropriate though may be for the short-term and medium-term trend to be in the same direction in adolescence of a new major trend.

The long running bear market may be approaching a major long-term support level. This situation may not provide a high probability of success for a short position even though the short position is in sympathy with all three trends.

Going With The Trend

The most ground is gained by going with the flow or to use an analogy, it's like swimming in a flowing river. If the market moves in the right direction for the client's portfolio, the result is a profit. It makes sense then to take a position appropriate to the direction in which the market is moving.

By definition, a rising trend means rises are greater than falls. The chances then become self evident of a long position gaining more than it loses.

A falling market means that the falls are greater then the rises. The odds are with the investor when holding a position with the trend.

In a rising market, the upward slope averages forty-five degrees. The proportional rise is equal to the proportional passage of time. This also means that for each two points increase, the market retracts one point on average. Positioning in a rising market provides odds of success as high as two to one.

The Market is Never Wrong

The market will move in a variety of ways for reasons that are sometimes beyond immediate comprehension. The market has absolutely no regard for the opinions of individual Financial Planners or Stockbrokers. Therefore, discussions need to be based upon what the market will do and not what the individual would like it to do.

Stairs and Elevators

Fund managers have an expression that states that markets go up via the stairs and down by the elevators. What this refers to is the fact that a bull market rises in fits and starts. Bear markets on the other hand, tend to have more rapid falls.

On the average, a rising market takes three times longer to cover the same movement in price as a falling market. That means profits may be achieved three times faster in a bear market than a bull market. It makes sense then to become comfortable and objective with Financial Planners entering the market on the side of being adjudged bottomed and bearish.

Know Your Trends

Any good trend picker will know what to do with a warning signal. They will reduce their exposure until the situation clarifies. Since no trend is totally reliable, it depends on other economic indicator situations, ie. inflation rate, 90 Bill rate, 10-year Bond rate, employment, monthly Balance of Payment, the Budget Projections, up and coming reporting season, global predictions and currency movements.

The Dow Jones - A Significant Trendsetter

The most watched stockmarket statistic in the world is the Dow Jones Index, a composite of 30 of America's largest companies. The United States has half the world's equity capital and the Dow Jones (DJ) is considered a snapshot of the overall market.

The companies in the DJ tend to be the world's 30 leaders, not just the 30 leaders in the US. Obviously, therefore, this makes the DJ position as a world economy as well. During the 1990's, investors looking to diversify out of Australia, found the DJ an attractive destination. The All Ordinaries Index rose a little over a half from the previous 1987 high; the DJ more than tripled. Even at the current depressed levels, the DJ is still well over double its pre 1987 high.

Since 09/2007 to 02/2009, the DJ has entered a severe bear phase, being the worst bear market since the Great Depression. The US stockmarket, which underwent severe asset inflation, is now experiencing a re-rating process. The result may be a dangerous deflationary spiral.

A case can be made out for being a bull market on the DJ because of the benign interest rates environment in the US - 10 year Treasury Bonds around 3 per cent (a four year decade low), thus the earned out period of 25 years which stocks can be expected to earn in 12 years.

Since earnings ratio (P/E) of the top US companies do not appear excessive of around 15 times forecast earnings, allowing for normal growth of 7 percent. The last time that happened was 1994 when the long bond rate was 8 per cent which made then 12.5 out (pay back).

Therefore, the stock market is trading at a 40 per cent discount. The answer is the fear of risk, evidenced in the variability of analysis forecasts; the volatility (larger price swings) of the DJ which is being highly exploited by the technical traders believing that the divergence between the US economy and equity markets is the greatest in living memory. Some claim the cause of the decoupling of the economy is caused by consumers burdened with such high levels of debt.

The Bottoming Out of Markets

This is the lull in the market, which just seems to be riding on the bottom. It can be a false sense of security that the trend is continuing. However, the market then rises off its lows and closes back near its one-month high. The market has rejected lower prices and the buyers have shown eagerness, taking control away from the sellers who initially drove prices lower. At least, there is considerable indecision and at most, there has been a change in control of the market.

The Topping Out of Markets

The market has been trending upwards strongly. It continues to close each day what turns out to be a high but sells off strongly which shocks the market. Buyers reassert control and close the day back near the high. It seems all is well but the periodical sell off has shown the trend vulnerability. At least there is a great deal of indecision. At most we have seen the last gasp of the real buyers who fill most of the buying orders. In the absence of buying power, prices are likely to fall.

Indicators of Confidence

The Goldilocks Syndrome - the position is everything is going so well, how on earth could it go better. In fact, when everything is going so well, there is a risk that it will fall apart. An investor who focuses on the market through all kinds of weather is best placed to do well on a continuing basis. This investor does not know just when to sell but they know that as night follows day, good times follow bad times and visa versa. It is the art of contrarian investors who recognise such times for what they are - times to buy, times to sell.

As any history of panics and crashes will show, you can't legislate against the lemming-like rush of the herd mentality which breeds booms and busts which is the same as greed and fear influencing the markets. Some markets will gradually build and then the pyramid game starts - more people hear about this marvellous market and partake. As more money drives up the market, until one day just about everyone has got set. Guess what - there is no one left to buy and the madness sets in. The Dutch tulip boom, the Australian Poseidon boom, the 1920's Wall Street crash, the 1980's Japanese equity boom and the 1990's US tech boom are all great examples and are marvellously immune from the legislation to ban the fall and encourage the rise.

Reaching the sentiment indication (right now it's at the bottom of the value range) is one of the best things you can do but you also need to check the fundamentals - the composite ASX index dividend yields and the measure of safety applying to the domestic or global economies. However, contrarian instinct is easily forgotten at extremes - when people sell in fear and buy in greed and then regret.

Support and Resistance

The basic concept is that when resistance is overcome that resistance becomes support. Sometimes, the benefits are not evident for some time but the longer the time that it takes for the benefits to appear; the greater will be the benefits providing a higher level of support than previously.

There are times when individuals and markets may drop below support levels but both will generally rise to higher levels.

1. Straight Line Support

   A straight-line support level is a previous important resistance level. Such line once breached not only becomes a substantial support level but has a seemingly magnetic attraction for action at some later date.

2. A Resistance Level

   A resistance level is the level a market reaches after the rise. The peak of the rise represents the level reached where supply (sellers) and demand (buyers) are eventually matched. As supply exceeds demand, prices drop. Important resistance levels are the highest levels reached. Sometimes, important resistance levels become historical highs which become resistance levels and once breached, these levels become support.

Rising Long Term Support

A linear regression line, or average may be taken through the All Ordinary Index over a long period of time. This average will be representative of the growth of the wealth of the country.

It may be assumed that the value of the assets supporting the value of share prices is continuously increasing. It is this fact that determines that the share market should always make new highs greater than the previous highs.

It follows then that, over a period of time, the level of support for the market or the levels to which the market may drop, is increasing. This average increase over a long period of time may be calculated for specific markets such as the share price index and used in time analysis.

However, what this assumes is that market troughs are made with less emotion than the peaks which therefore in regard to troughs situations, the start of a new beginning or base of market action is more suitable for analysis in a rising market.

For example, the support level for the Australian All Ordinaries Index plotted as a line chart from 1884 to 1930 which means during this period, the market was supported above this point. By the 1931 Great Depression, the market had penetrated this support and the trough that formed became the new rising support level.

This support level persisted until the support was penetrated in 1973 whose trough or low that was formed became the new support level that was tested in November 1994 and held.

When the market drops, individuals will sell their securities through fear of loss. The most pessimistic will be the first to sell and as the market continues to drop, the more optimistic will lose hope and sell.

There comes a time when there are no sellers left willing to sell the securities that they hold. If there are no sellers, the price can go no lower. Because the market invariably overreacts, buyers recognise the value and commence to buy.

The lowest point that the market is able to reach becomes a support level. The prices are unable to penetrate below this level. The longer the period that the support level has been in existence and the more times that the market has tested this level, the stronger is the support level.

As the price increases, more buying occurs. The initial buyers are low risk averse, then the more risk averse buyers, the trend is confirmed and finally, the high-risk averse buy. Eventually, there are no buyers in the market or more realistically, the buyers and sellers are evenly matched and the price stops rising - then a resistant level has been reached. This price level will remain as resistance until breached on some future upswing. Once breached, this resistance level will become support.

Conclusion

This concept of support and resistance (also being part of BCM's technical analysis filtering tools) should be important to Financial Planners as it is elementary to analysis of both macro and microeconomics effect on share prices. It should be noted that if a line can be drawn across the market tops or troughs approximately parallel to the support line or resistance line. This will form a "Channel". This channel is an indication of the levels that the prices may rise and fall within.

The ability to read and understand the signals given provide with a high degree of reliability, the likely direction of the market. This information provides the Financial Planner with an edge to add value to client portfolio. Where this support and resistance strategy is applied with consistent discipline, it may perhaps be profitable. Basically, the same technique applies to recommend to a client to take advantage of a rising market by being over weighted to a sector specific.

The Psychology Behind Achieving Real Value Added

To achieve real value-added profitability of a client's portfolio, some Financial Planners prefer fundamental analysis of economic data while others have had more profit success at technical analysis system focusing on trends.

However, success or failure in placing and reviewing a client's portfolio is a result of interaction between the market, the system and the Financial Planners psychological make-up.

Which Category Do you Fall Into?

Most Financial Planners will approach the market with an inherent tendency of some sort with the majority having a tendency toward optimism. However, all degrees between extreme optimism and pathological pessimism will exist somewhere.

If a Financial Planner finds that they take more long positions than short positions in a bear market, that person with an optimist's tendency will do better when advising in a rising trend. In-depth analysis and categorising ones errors of assessing the markets will soon alert the planner to any problematic tendencies they have. This awareness most importantly can alert the planner to times of weakness and so avoid the consequences.

Risk Aversion

On the other hand, markets do not exist without their risk such as instability of returns over time and a chance of loss of capital, something all Financial Planners would prefer to avoid the pain.

Therefore, whatever system the Financial Planner finds works well for them, ie. "Dollar Cost Averaging", the sooner they act on information about the market such as release of economic data, newspaper articles, etc.

Low risk averse planners have a healthy respect for risk and act accordingly on information changes about the markets whereas the high risk averse planner needs more confirming information to convince him to act subsequently ending up on the wrong side of the market.

Information Redundancy

Information about a market and related areas such as the economy is discussed and circulated every day. Much of this information is simply rehashed confirmation of earlier information, which soon becomes redundant. In other words, the more bearish a market seems, the more redundant will be the negative information that is circulating. The length of time and how much confirmation is needed indicates the level of risk aversion.

The high risk averse Financial Planners are relying on the redundant information before coming to a decision to trade and since this information is well known and factored into the market, it is little wonder that high risk averse planners have problems in a speculative market.

Measuring the Mood of the Market

There are few technical indicators that can be used to achieve this end but Financial Planners would rather run on a prevailing market sentiment. For example, if information disseminated by the market is positive, the optimists will buy more confidently and the good news will act to reduce the low risk averse amongst the pessimists.

The Market at a Low

As the market declines, long strips of unfavourable information written about interest rates, Dow Jones Index, Japan and a combination of fads at the time why people should worry about the economy. Most of this self-reinforcing, negative air of pessimistic information will however be highly redundant. However, what sums up the greatest air of despair, the earliest buyers are the low risk averse or realistic buyers who will not delay in entering the market because they do not fear the risk of buying on the first sign of change.

Given the strong air of pessimism in the market, it will feel risky to buy into the market at this point but not so for these early buyers who will be followed by the lowest risk averse optimists and hold for the long haul to make a profit.

As share prices move up, most positive information will circulate and as a result, the higher risk-averse optimists will become sufficiently comfortable to purchase.

Choosing the Strongest Stock in the Strongest Sector Boosts Your Chances of Success

Unless we are adopting a "passive index" approach, all investments and tracking methods involve trying to find outstanding shares.

In the investment world, there are two basic approaches to finding the best shares. In the professional analysts-speak, these are known by the jargon terms "bottom-up" and "top-down".

The "Bottom-Up" Approach

Is known simply as "stock picking". Analysts who employ this method, look at the entire universe of shares and try to find the best ones by applying various tests. There is a wide range of possible tests that may be used, based on accounting data, market price data and subjective judgements like quality of management.

The "Top-Down" Approach

Is the search for the strongest FMs/DSOs on the logical grouping they belong to. Assuming that analysts tend to look anywhere in the world, they will compare all the available national markets and select the best ones. Then they take only the best markets compared to all industry sectors within them and select the best ones. Finally, they take only the best sector, compare all shares or managed funds within them and select the best ones. Again, there is a wide range of possible criteria that may be used to access which are the best.

Relative Strength Index

Technical analysts use both top-down and bottom-up approaches except they focus only on market data, primary price for the criteria used to make the judgements. One of the most powerful of the possible technical analysis tool is also one of the simplest - "relative strength".

Relative strength is simply one thing compared to another to see which is increasing the price faster. To do this, the comparisons must have a common base so if we divide the prices over the time of the listed FMs/DSOs by a common base such as the market price index, we will be able to identify which shares or a fund managers price, are rising the fastest.

We are not restricted to shares; we can also use the first indexes of industry sectors to find the sectors that are the strongest compared with the overall market by dividing each sector index by the general market index. We could also do this for national markets compared with a world index.

Analysts have found that the strongest FMs/DSOs or sectors tend to remain the strongest in their field for some time. If we can find the strongest portfolio synergy and stay with them while they are performing better than the market overall, we should have a superior outcome. This has an advantage over the fundamental analysts who might identify what is thought to be the great share based on its prospects and management but the market hasn't recognised yet. The technical analyst is therefore looking to add the timing dimension.

Relative strength analysis can be done a few different ways. It can be done by hand using the Share tables section and a calculator. The computer literate reader could use a spreadsheet. Technical analysts would use their charting software but these methods will vary slightly depending upon the features built into each charting software. We could simply chart the relative strength of every industry sector and usually inspect the charts to find which has risen fastest in recent times.

However, we can hone in on them faster if we shift them mathematically. I want to find the sectors that have gone up the most in the last three months. To do this, we take the price now and divide it by the price three months ago. This will indicate which sectors are rising in price and by what percentage. We then select the ones with the strongest percentage. If a three ninth relative strength sector produces too many sectors on the rise, then narrow the field down, either 44 or 22 trading days, sample, instead of 66 days or three months, sample, so as to make a valid comparison.

Therefore, having found a relative strong sector or stock over a specific period, the next step will be to do our research and to see whether it will fit into the portfolio.

When To Hedge Global Equities Portfolio

If you've parked money in a global equity portfolio, the chances are you will be wondering or even fretting - here are 13 ways of how much the Australian dollar might affect your returns in the future.

1. A rising A$ reduces the dollar value of an investment in foreign securities, eroding any gains in share prices.
2. The decline of the A$ since late 1995 from around 75c, naturally boosted returns from global stock markets by 3 per cent a year according to Van Dyk Research.
3. In a rising A$ environment, hedging seems to be a prudent decision. Your fund manager will do the hedging for you.
4. Buy and hold investors who are in for a good five to ten years shouldn't be concerned with the daily gyrations of foreign exchange markets.
5. Fund Managers have three options when managing currency exposure -
   1. They can hedge their entire exposure back into A$.
   2. They can leave all of their exposure unhedged.
   3. They can hedge some of their exposure back into A$, depending on their view of the A$.
6. Hedging usually involves taking a position in the options in forward markets to offset the currency exposure implied by holding an underlying asset. In other words, in the A$ may have an impact only on the US investments. Regional funds that invest in locations such as Europe and the Asia-pacific may not suffer significant losses if the A$ rises.
7. The best way to look at it is to hedge the core exposure to A$, ie.
   1. If you take the long-term view on your investments, then its better to leave an international equities portfolio unhedged for the diversification benefits.
   2. In the short-term, with the probability of the A$ moving higher in the next year, you can move some of it into fully hedged.
8. The problem is the switching - you can incur fees.
9. You have to be very confident about the A$ view. If you fully hedge and the A$ falls, you will get burnt.
10. The most sensible advisors would advocate sticking to a long-term view. When it comes to predicting currencies, they are much harder then equities.
11. The best way to look at it is to have a core exposure and hedge the excess. For example, if your minimum exposure to non-A$ currencies approximately 25 percent than anything above that, should be fully hedged.
12. Financial Planners should have information about whether a fund hedges its currency exposure.
13. If you are an investor with a very long term view of say five to ten years, it can be more cost effective not to be hedged at all, as currency effect has tended to be washed out of the equation.

Moving Averages

Moving averages are an important benchmark as a "trend following" tool for financial planning such as the price of a security, unit price of Managed Fund or an indice of economic indicator over a period. As the price of the security will change from day to day, the average over the particular period selected will move.

Simple Moving Average

A simple moving average is the traditional and most commonly used method which is basically the weighted average of a series of prices over a period, divided by the selected period to arrive at the new moving average.

This moving average is plotted on a price chart to create a picture of the average of the price active compared with the actual price action.

The longer the number of periods used in the construction of the moving average, the lower will be the sensitivity to the present price action. The signal from the longer term moving average will occur some time after price action has reversed meaning that it is not as good an indicator to exit the market as the actual day to day prices.

It would be appropriate to ensure the extent of the swing in the wrong direction after taking a position is not going to exceed 5% of the account balance. The period of the moving average used should be such that an exit signal is given before an adverse price action depletes the account balance by 5%.

Therefore, the use of shorter periods for the moving average will produce a greater sensitivity to present price action. This may be to the extent that quite a small movement in actual price can result in premature closure of positions taken. The single moving average is the easiest timing single to work with. To normal price action, this may be over sensitive, creating numerous buy and sell signals. The entry and exit rules may be adjusted to require that moving average be increased or it may be that the close should be above the moving average for two or three consecutive closes. Another alternative is that the entire price bar be above or below the moving average before a position is taken.

It may be realised that the variables are:

• the adjustment of the moving average period
• the extent that price action deviates from the moving average
• the time period of the deviation

Double Moving Average

A study carried out by Merrill Lynch in 1979 overwhelming revealed that the duel moving average was 300% better at predicting both long and short-term trends than triple moving averages. The duel moving average uses a longer term moving average to capture profits in a trading market. The shorter term moving average provides entry and exit signals.

In a trending market, the longer term moving average (less sensitive) remains clear of minor corrections and fluctuations. This results in the capture of a greater portion of the trending action.

The crossing of the short term and longer term moving averages provide entry and exit signals. The shorter moving average provides the better signal in a poor trending market and the longer term moving average performs better in a well trending market. It follows that a change in the market from sideways to trending will be signalled by the shorter term moving average identifying the trend and the longer term confirming the trend change.

Entry may be made in a rising market when the daily index bar is above the short-term moving average or when the short term moving average crosses above the longer term. The position may be exited out when the short term moving average is above the index bar or when the short term crosses the long term moving average.

The periods used for the two averages may be adjusted to suit the particular mood of the market and to suit the review temperament of the Financial Planner. A frequent combination used is 5 days and 21 days.

Application of Moving Averages

The feature of moving averages is to determine the process of using the combination optimised time periods that produce the best results on that data. While optimised combinations may remain valid for reasonable periods of time, the mood and nature of the price action changes. Moving averages can be profitable for clients because they face adherence to positioning maxims such as asset allocation with the trend, cut losses short and let profits run. Moving averages work very well in trending markets that occur for approximately one third of the time. Like any analytical tool, moving averages should be used in conjunction with other tools to confirm or deny as to the long or short-term profitability of a client's portfolio.

Other Tools

1. The Oscillator

Now, to introduce another aspect of price action. The rate of change or the extent of change compared to rate of change over another period.

The movement of price or indice in a market can be compared to the movement that occurs in a line of traffic. When the traffic starts moving from a standstill, some time elapses from the time the front vehicle starts to move. The line of traffic takes time to come up to speed. The rate of acceleration of the tail end of the stream will ultimately match that of the lead vehicles. The opposite occurs when the traffic stream starts slowing down.

The acceleration rate of the lead vehicle is predictive of the speed of the middle of the stream some time in the future. The oscillator essentially measures this rate of change to predict future events.

To understand the construction of the oscillator, consider two moving averages, an 18-day and a 9-day. The 9-day will follow the price action more closely than the 18 day. The crossing of the averages will represent changes in price/indices action. The drawing out of the 18 day moving average to a straight line allows the 9 day moving average (known as the zig-zagging variability) to oscillate above and below this straight line (known as the index or zero line).

The oscillator alerts the Financial Planner to the overbought and oversold conditions in the market. In a rising market, the overbought indication signals that the traffic at the head of the line will soon start to slow down and acceleration will become negative. In an oversold market, the oscillator signals that the traffic should soon start moving. It should be appropriate to wait until the change actually begins to occur before taking a position.

2. The Channel

Channels may be defined by the use of the trend lines or moving average bands. For example, an All Ordinaries Index will show over a period of time and average rise and fall within a range reflecting the passage of events that occur during the economic cycles.

The simplest way may be to take a long position (buy) in a rising market when price action reverses after coming in close proximity to the support line. The reverse position occurs when the price action is in close proximity to a line drawn across the average of the past tops.

This channel technique only becomes available after a particular market has established itself within a trading range of support and resistant levels which is an awareness signal that this is a failure of price action to reach the upper level or the lower limit may be an early indicator of a weaker trend. Also, the major tops are associated with high volatility and most major bottoms are associated with lower volatility.

3. Fibonacci Numbers

Fibonacci is a thirteenth century mathematician who wrote a number of major works such as the introduction of the Arabic number system and his numeric system gradually replaced the system of Roman numerals over the years. This sequence was believed to be known to other ancient civilisations, notably the Egyptians and Greek cultures.

The ratio known as the Golden Mean is displayed in the construction of the great pyramid of Giza and many other major constructions undertaken.

The sequence then runs 1 2 3 5 8 13 21 34 55 89 144 233 377 610 987 and on to infinity. The number sequence is simply produced by adding together the last two numbers in the sequence. The sequence starts at adding to the following number 2 to produce 3 and the next number 2 to 3 to produce 5 and so on.

A number of interesting relationships exist between the numbers, including the relationship of any one number to the next. Each successive number is approximately 1.61818 times the previous number and each previous number is approximately 0.618 times the next highest number. Therefore, the ratios of the alternate numbers becomes 2.618 and its reciprocal 0.382.

These ratios appear frequently in nature and have relevance in the mathematics of the universe down to technical analysis with greater frequency than the theory of randomness suggests.

The application of these numbers may be used to determine the possibilities of possible retracement, times between significant tops and bottoms and double moving averages.