Does the Australian ASX rally have further to run?

The ASX 200 index has risen 5.6% so far in April, and technical analysis suggests there’s strong momentum behind the rally. The key level to watch is 5352. Keep an eye on the price to earnings ratio too, as it remains high.

Source: Bloomberg

The ASX has gained 5.6% so far in April, but many in the market are expecting a reversal and so the question is what levels does the ASX need to break through before we can definitively say this rally has legs.

The ASX on Wednesday managed to close above 5200 for the first time since 4 January. There still looks to be plenty of momentum behind the current uptrend and the MACD oscillator is far off indicating a reversal. A close above 5300 would bring the index close to the 61.8% Fibonacci retracement line from where the index sold off at the start of August.

But the level everyone in the market is watching carefully is 5352, which is where the ASX closed on 23 October marking its highest close since the early-August sell-off. Of course, should the ASX be rejected at any of these key levels, that could signal we are in for a sharp decline and may be a good entry point for short positions.

The ASX still looks overvalued based on price to forward earnings expectations, despite the sell-off we have seen. The forward P/E is sitting almost 1.5 standard deviations above the long-term average. Based on the past ten years, it is usually when the forward P/E ratio is above 17 that we see sharp reversals. As of Thursday, the ratio is 17.2, which should raise some red flags.

The big increase in stimulus spending and investment activity in China in the first quarter has had a major impact on the ASX. The materials sector is the best performer in the index, gaining 18.6% year-to-date. The global equity rally in April has been driven by technology, industrial, materials and energy stocks, also known as TIME stocks.

This has certainly been true for the ASX, although for it to break out to the highest levels seen since early-August it is going to need the banks to start finding buyers given their heavy market capitalisation weighting.

At 28.2% of total market capitalisation of the ASX, banks still make up a very weighty part of the market. The financial sector as a whole makes up 45%. Clearly, for the ASX to start moving steadily above the 5350 level, investor appetite in the financials space is going to need to increase dramatically. Much of the recent move has been driven by the materials space, which has seen its market cap weighting shrink to 15% from its highs of 29% in 2012.

Until last year’s August sell off, the biggest seven stocks in the ASX still cumulatively accounted for 50% of the market. The seven comprise the “Big Four” banks – Commonwealth Bank of Australia, Westpac Banking Corp, Australia and New Zealand Banking Group Ltd and National Australia Bank – mining giants BHP Billiton and Rio Tinto and telecoms and media company Telstra.

While their weight in the index has shrunk to 42%, largely driven by the declines in BHP Billiton and Rio Tinto, they will still be key drivers behind any moves in the index above 5350.

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