Resources still the key

Lesley Beath | 09 Sep 2013

The views expressed in this report are those of Lesley Beath and may differ from Morningstar's views.

Disclaimer: To the extent that any content in this report constitutes advice, it is general advice that has been prepared by Lesley Beath without taking into account the particular investment objectives, financial situation and particular needs of any individual investors. If necessary, you should consult with a licensed investment adviser or dealer in securities such as a stockbroker before making an investment decision. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

Overview

There was some interesting action last week. India managed to post a strong gain after bouncing from support the week prior, and Chile did likewise. Russia also posted an impressive gain.

These reversals are tentative at this stage but they are noteworthy, as failure to hold above support would have, in all likelihood, led to an increase in selling pressure.

China and Brazil also fared well. Both markets have been rising since early July, along with the ASX Materials Index, although the latter has struggled since mid-August while China and Brazil have kept moving higher.

The longer-term charts of these three are similar, although they don’t always have a high correlation. They have moved in similar cycles since February, but the ASX Materials Index was rejected from resistance in mid-August and it has been unable to overcome that resistance.

That resistance, and the resistance in relative-performance terms, has been highlighted in recent reports and it remains the key to upside potential.

The latter is probably the most important as a topside break would signal that a solid period of outperformance by the resource side of our market was emerging.

If we look at the action on the All Ords, there is still no suggestion that the resistance of the mid-May highs will be successfully overcome.

The ASX Retailing, Transport, and Diversified Financials are also nudging towards their May peaks. Telecommunications and Insurance pushed towards similar resistance a couple of weeks ago and have since retreated.

Energy, Consumer Discretionary and Healthcare are the only major indices to push beyond their May highs. Of these three, Energy looks to have the most upside potential.

The ASX Energy Index pushed above its first line of resistance last week but the highs of February 2012, which sit just above current levels, will pose a significant barrier.

The oil price (West Texas Intermediate) has already cleared the February 2012 resistance, leaving the April 2011 high at $113.93 as the next barrier. We looked at the oil price a couple of weeks ago, noting its resilience as it tackled its February 2012 highs.

Action suggested that a topside break was on the cards and it did not disappoint. It should be noted that not all oil markets have cleared their respective resistance levels and there is potential for a pause ahead of any possible topside breakout.

The banking stocks can push marginally higher but a strong rise is not anticipated. With the exception of National Australia Bank (NAB), the majors have done very little since late July and risk remains skewed to the downside.

So, there is really no change to the outlook for the Australian market. Upside potential appears limited at this stage.

In the US, the S&P 500 nudged higher over the week. This was not unexpected as the index was oversold and short-term momentum indicators were improving from oversold levels. But the medium-term outlook suggests that risk remains to the downside.

We looked at the US equity market in some detail last week, highlighting potential downside over the next few months.

I also highlighted the US T-Bond/S&P 500 ratio, which had been rising. As you know, I look for a change in character or a turn in this ratio to signal a potential change in the equity market.

Last week, I noted there was nothing to indicate that a change in trend in the ratio was imminent, but as T-Bonds had just completed a Fibonacci 61.8 per cent retracement of the February 2011 to August 2012 rally, there was scope for a bounce that could pressure the ratio to the upside.

The bonds were sold off over the course of the week, but a quick rebound on Friday kept price above the August lows. This fall in the bonds resulted in a decline in the ratio - it is now sitting just above the early August lows.

So, for now, this indicator is not suggesting a deep pullback in the equity market, so there is room for some near-term stability.

As noted last week, I think China appears less risky at this stage. The Shanghai ‘A’ Shares Index has been rising since late June and now data coming out of China is suggesting the economy may be performing better than anticipated. And there is a hint of optimism that the global economy may be recovering.

As an aside to that, it is interesting to note that the Baltic Dry Index jumped 19 per cent this week in London, the biggest weekly advance since August 2010. That rise has pushed the index above the upper limits of the range that has been in place since April/May 2012.

The Baltic Dry Index, according to Investopedia, is a shipping and trade index created by the London-based Baltic Exchange that measures changes in the cost to transport raw materials such as metals, grains and fossil fuels by sea.

The Baltic Dry Index is a composite of three sub-indexes that measure different sizes of dry bulk carriers (merchant ships) - Capesize, Supramax and Panamax. Multiple geographic routes are evaluated for each index to give depth to the index’s composite measurement.

Changes in the Baltic Dry Index can give investors insight into global supply and demand trends. This change is often considered a leading indicator of future economic growth (if the index is rising) or contraction (if the index is falling) because the goods shipped are raw, pre-production material, which is typically an area with very low levels of speculation.

So, this break above the April/May 2012 highs is encouraging, although I would like to see the ASX Materials Index overcome its key barrier before becoming too optimistic.

Lastly - a quick word on the Australian dollar. The Australian dollar is showing some improving signs in the short term, although it really needs to break above the 93-cent level to confirm medium-term upside potential.

In May, I spoke about downside potential towards the mid-80-cent level. That was the measured move from a symmetrical triangle that had developed between August 2011 and March 2013. Is that target still valid?

While price targets can give us an idea of upside or downside potential, I don’t think we should get too hung up on them. Given that the Aussie dollar was trading at 98 cents when that target was put forward, I think the technical outlook has basically captured the bulk of the move.

We may well end up getting back to the mid-80s, but we should get some warning if that is to be the case.

For now, we can assume that risk is skewed marginally to the upside, but as I just said, we need a break above 93 cents to push it into trending mode. Until that happens, expect more oscillations within the 88-93 cent range.