The (top) fat side

The moves in global markets and the ASX over the past six to seven trading days have led to statements such as ‘rallies are back’, ‘new market order’ and even a ‘new bull market’.

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As much as I would like to agree with the positive sentiment, several key macro headwinds remain on point and the drivers of the past week are now showing signs of topping out, ie. iron ore, oil markets and US markets.

I stand by my strategy that the ASX is in a horizontal trading pattern with a ‘tubby’ and ‘squat’ profile – a historically wider trading range (tubbiness) with relatively low aggregated capital growth (squatness).

I believe two scenarios are playing out:

The first scenario

Markets (the ASX included) will collapse and become fundamentally ‘cheap’ – the six-and-a-half-year bull market only ended six months ago. The correction in January had distinct characteristics of being overvalued in the current cycle and is looking for structural weakness.

Some would argue this may have happened on 10 February with what looked like a ‘final capitulation’ trade.

However, were markets fundamentally cheap after this event? I would argue they were cheaper and the selloff from January had overextended, giving rise to a buy call. But are they fundamentally cheap? US and European markets were trading at historically fair multiples rather than what I would describe as ‘fundamentally cheap’.

The ASX’s cyclical side (resources and energy) were ‘fundamentally cheap’ and any moves up in oil and industrial metals (which has transpired) was going to drive a rally in this space.

I would agree that in mid-February there was a point of ‘fundamental cheapness’ in the ASX. But that price point has closed, and I am yet to see a reason for a leg to 5400 points and above.

Underlying company earnings are, if honest, underwhelming and the AUD, China and a few other factors are likely to cap the rise in the index.

The second scenario

Markets will remain volatile and trade in a directionless manner with a tubby and stout 2016 profile. Macroeconomic fundamentals, the oil price and inflation will leave markets in a state of flux.

Macroeconomists see the financial crisis as a three-pronged event, starting with US sub-prime, then a European sovereign crisis, and followed by EM devaluations and capital outflows – particularly in China.

The economic targets coming out of China’s National People’s Congress shows the country is going to work as hard as possible to stave off its hard landing fear.

The release is a medium-term positive for industrial metals and a positive for cyclical resource stocks, but it has not changed the macro fundamentals, and that has been reflected (so far) in data releases. Industrial production at 25 year lows, fixed asset investment on the slide, retail sales the same, trade balances that are becoming sporadic and inconsistent, and a sticky translation to a ‘consumption nation’.

In short, my strategy for the ASX is that trading a ‘tubby’ and ‘stout’ is likely to continue. We see several signs that involve the markets moving back towards the mean level of the past six months. The range trade is intact and it is likely to move off the current highs today.

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