• Share markets were mixed over the past week with good economic data propelling the US share market to record highs and hopes of more ECB stimulus helping in Europe, but with soft data and profits weighing in Japan and Australia and increased Ukraine tensions weighing across the board. Bond yields generally fell back again on the prospect of more monetary stimulus in Europe. While the gold price rose slightly, oil and metal prices fell. Notable on the commodity front has been the renewed fall in the iron ore price partly on the back of worries about the Chinese housing market. Despite this, the seemingly Teflon coated Australian dollar rose over the week.
• The somewhat messy and desynchronised global growth environment remains clearly evident with good news out of the US, but Europe and Japanese data disappointing and geopolitical issues continuing to hover in the background. This all means occasional bouts of uncertainty for investors but as long as the broad trend in global growth is one of improvement, desynchronisation is not bad because it means central banks will stay supportive. Perhaps the bigger risk is that the longer rates stay low, the longer investors will expect this to remain the case which could set up bubble like conditions in various assets as investment yields (be they bond yields, dividend yields, rental yields, etc) get pushed ever lower as investors search for yield. However, for growth assets we look to be early in this process.
• In Australia, the June half profit reporting season is now wrapped up. While aggregate earnings growth in 2013-14 came in slightly lower than expected at the start of the results season thanks to misses by some large cap stocks (notably BHP), at around 12% it was still solid with two thirds of companies seeing gains in profits on a year ago. Rising dividends suggest amongst other things that the corporate sector is reasonably confidence in the outlook. See below for details

Major global economic events and implications

• US economic data was pretty favourable. While home prices were mixed in June and new home sales fell in July, pending home sales rose strongly, the Markit services conditions PMI remained strong, consumer confidence rose and durable goods orders surged. While a 23% rise in July durable goods orders owed to strong aircraft orders, the underlying trend is solid particularly for capital goods orders pointing to solid growth in business investment. Stronger investment also drove an upwards revision to June quarter GDP growth to 4.2% annualised from 4% initially reported.
• While momentum in money supply and bank lending improved a bit in July in the Eurozone, various confidence surveys softened in August confirming the loss of momentum seen recently in European growth adding pressure on the ECB to do more to stimulate growth. Quantitative easing focussed on the ECB using printed money to buy securitized bank loans looks likely to be launched soon.
• Japanese data for July disappointed with a smaller than expected gain in industrial production, continued softness in household spending, a rise in the unemployment rate and inflation falling slightly to 3.4% year on year, or 1.4% after the sales tax hike is allowed for. That said, the jobs to applicant ratio held at its highest since 1992 suggesting companies must be reasonably comfortable. Nevertheless, the soft July data will put more pressure on the Bank of Japan to consider further monetary easing.
• Korea was a bright spot though reporting a much stronger than expected gain in July industrial production.

Australian economic events and implications

• Australian economic data was a bit soft with falls in June quarter construction and equipment investment and a fall in new home sales in July. Private credit growth softened a bit after a stronger than expected rise in June with housing related credit looking like it has peaked on a monthly basis. Business investment plans for the current financial year also point to another decline on the back of falling mining investment. However, this has long been expected and there are some positive signs on the investment front. In particular, residential construction is continuing to rise and investment in what the ABS refers to as “other selected industries” looks like rising solidly in the year ahead. So dwelling construction and non-mining investment are helping to provide an offset to the slump in mining investment.
• The profit reporting season is now over and while the quality of results trailed off at the end as usual, overall it was pretty good. Particularly compared to the nervousness ahead of the results being released. 54% of companies have exceeded expectations (compared to a norm of 43%), which is the best result in nine years; 68% of companies have seen their profits rise from a year ago (compared to a norm of 66%); 65% of companies have increased their dividends from a year ago (up from around 60% in the last two years); and 59% of companies have seen their share price outperform the market on the day they released results, which is the best result in four years. Key themes have been strong profit growth for resources (notably Rio, although BHP disappointed a bit), banks doing well (with a good result from CBA) but no better than expected, ongoing cost control making up for still soft revenue growth and strong growth in dividends reflecting investor demand for income and corporate confidence in earnings prospects. Australian earnings growth for 2013-14 looks to have come in around 12%, which while down a bit from expectations a few weeks ago due to the BHP result causing a slight downgrade for resources, is still a solid outcome. Resources led with a 27% gain, followed by banks up 9% and the rest of the market up around 5%. Consensus expectations for the current financial year remain for 5% earnings growth, but this looks a bit low to me.

 What to watch over the next week?

• In the US, expect more solid readings from the ISM and Markit manufacturing conditions PMIs (Tuesday) and services conditions PMIs (Thursday), but the main focus is likely to be on jobs data (Friday) which is expected to show another strong gain in payrolls of 220,000 and the unemployment rate falling back to 6.1%. The Fed’s Beige Book of anecdotes on the economy (Wednesday) and trade data (Thursday) are also due for release.
• In Europe, the main focus will be on the ECB’s meeting on Thursday, where, following President Draghi’s recent comments regarding falling inflationary expectations, there is a 50/50 chance that it will unveil a quantitative easing program involving the purchase of private sector asset backed securities or if not allude that it’s on the way.
• The Bank of Japan also meets Thursday but it’s unlikely to make any changes to monetary policy.
• In China, the official manufacturing conditions PMI for August (Monday) is likely to have fallen back a bit in line with the HSBC flash PMI already released.
• In Australia, the RBA is expected to leave interest rates on hold yet again. Nothing much has changed since Governor Steven’s recent Parliamentary testimony where he expressed comfort with current interest rate settings. Rates have already been cut to record lows and the housing sector has led the response but with mining investment still slowing, non-mining capex still soft and the $A still strong its way too early to consider raising rates.
• It’s also going to be a bit of a data avalanche in Australia. The main focus is likely to be on the June quarter GDP data and here the news is unlikely to be good. Our expectation is for GDP growth of 0.5% quarter on quarter (or 3.1% year on year), but weak readings for net exports, consumer spending and investment suggest the risks are all skewed to the downside. In fact there is a high risk of a slight contraction in GDP. Inevitably this would invite talk of a recession, but as was the case with the previous three negative quarters seen in the last 23 years, a recession is unlikely. First, the soft June quarter result will be payback for the unexpectedly strong trade driven growth seen in the March quarter. So best to average the two quarters out. Second, a range of timely indicators relating to housing, retail sales, consumer confidence and the jobs market point to stronger conditions in the September quarter.
• In terms of other Australian data releases expect to see a further rise in house prices (Monday), a -0.7%  contribution to growth from June quarter net exports, weak public demand and a bounce back in building approvals (all Tuesday), another large trade deficit and modest growth in July retail sales (both Thursday). The AIG’s business conditions PMI’s will also be released.

Outlook for markets

• While shares have seen a strong recovery from the mini-slump seen in early August, the correction season consistent with the old adage “sell in May, go away and come back on St Leger’s Day” is still upon us with September historically being the weakest month of the year for US shares partly due to tax loss selling and the September-October period often being tough in Australia.

• However, despite the risk of another correction the cyclical bull market in shares likely has a lot further to go as we still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops.Valuations remain okay particularly once low interest rates and bond yields are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In fact, in terms of the latter there still seems to be a lot of wariness regarding shares. Our year-end target for the S&P/ASX 200 remains 5800.
• Low bond yields, eg 10 year yields of just 0.5% in Japan and 3.5% in Australia, will likely mean soft returns from government bonds.
• The combination of soft commodity prices, the likelihood the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. Expect to see $US0.80 in the next few years, but getting the timing right is hard.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist, AMP Capital

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Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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The recent policy initiatives introduced by the Bank of Japan (BOJ) are the latest in this long and bewildering chain of events as central banks attempt to offset the many and varied deflationary forces brought about by deleveraging and the accompanying austerity measures.

Having been hitherto staunchly conservative, investors are rightly stunned at the scale of Japanese QE, where the central bank has started a programme of stimulus on a massive scale.

Where the Fed may have surprised investors initially with its programme of $85bn a month, or 7% of GDP, the BOJ have trumped that with its programme of 15% of GDP, an unprecedented move. This will see it buying 1.6x net supply, completely and deliberately crowding out traditional investor and swamping the markets with further liquidity.

This has not surprisingly seen the Yen fall sharply, and has prompted a big stock market rally. The intention of the BOJ is to end 20 years of deflation and get inflation up to 2% pa by forcing investors out of bonds and into riskier assets.

It will also force domestic Japanese investors to look overseas for their returns;  with the prospects of  a non-existent bond yield, and a depreciating currency, why wouldn’t they seek a return in higher yielding foreign bond markets? Faced with a decline in the domestic population of 30%, I suspect the reflationary policies will ultimately fail, but at least the authorities are giving it their best shot.

The irony is that the underpinning this gives to risk assets feels at odds with both fundamentals, and leading indicators. Equity markets have performed well this year, but earnings revisions have turned negative and growth prospects have been downgraded, both for corporates and for sovereigns.

Within equities, cyclicals have underperformed defensives, emerging markets have underperformed the developed markets and commodities have been under pressure. It doesn’t feel like the backdrop to positive equity returns. Within Europe the recent Cypriot bailout is an additional reminder as to the fragility of the Eurozone and its financial system, and is a worrying precedent for the periphery as to what the future may look like.

Indeed, it runs the risk of undermining the banking system further by prompting deposit flight from the domestic banks. Growth appears to be difficult to come by, and the recent downgrade to growth expectations in France is the latest disappointment to hit the region.

The banking system in the US looks to be much better capitalised and well placed to fund the credit expansion required by a growing economy. Although the housing market continues to recover, the latest job statistics appear to show that growth is again slowing, in all likelihood finally reflecting the impact of the fiscal cliff impasse.

Until this is resolved, it is difficult to see confidence truly recovering, and there will of course remain the real and meaningful impact of the spending cuts and tax rises acting as a headwind to growth.

But if investors have learnt anything over the last couple of years, it is that despite anaemic growth, faced with a tidal wave of developed world QE, they ultimately have nowhere to go other than equities, not least of all because of the yield pickup offered by this asset class.

It should perhaps come as no surprise that in nearly all regions of the world, the income and higher yielding strategies have been the best performing. As long as the central bank taps are turned on I expect this trend to continue.

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Beware crystal ball gazing

Financial advisers and investors should think carefully before acting on the latest round of New Year predictions for economies and markets, van Eyk Head of Strategic Research Jonathan Ramsay cautions. 

Mr Ramsay said while crystal ball gazing was popular this time of year, planners and their clients need not take this as a sign that predictions should be acted on or that they were any more relevant than predictions made at other times. 

“There’s no inherent reason why the experts should be better at predicting the future now than they are at any other time of the year,” Mr Ramsay said. “One needs to be careful that someone’s holiday reading isn’t allowed to set the agenda for the rest of the year.” 

He said it was also an interesting exercise to look at which experts and commentators made their predictions from previous years readily accessible so their record could be judged and which ones appeared to ”wipe the slate clean”. “Those who are prepared to raise last year’s predictions and discuss how close they came to reality and why should be treated with more credibility,” Mr Ramsay said. 

Despite these reservations, Mr Ramsay said attempting to predict the future and identifying which themes will shape markets in 2013 could be a useful exercise because it forced analysts to refocus their views. The results could also be beneficial to financial advisers and their clients as long as they understood how to use them properly. 

Mr Ramsay offered these tips:

•  Try to avoid clutching at opinions that will make you feel good about the performance of your investments last year. “With so many views flying around there is something to suit everybody’s prejudices,” Mr Ramsay said.
• Don’t overemphasise the link between investment themes and asset class returns. “While it’s easier to talk to clients about big, tangible market themes they do not necessarily translate into market performance,” he said. Furthermore, many of the most prominent themes will be well known and already priced into markets. “Having a strong valuation process and discipline can help identify which themes are the most fully discounted by the market.” 
• Themes and predictions need to be assessed in terms of the probability that they will be correct and what would happen to an investment portfolio if they aren’t. “It’s important to assess what would happen to your investments if the future doesn’t pan out as you thought it would and look at which scenarios have the biggest impact on returns,’’ Mr Ramsay said. “Again, having a rigorous approach to asset valuation helps you identify which outcomes matter most.”

For example, van Eyk believed that the probability of a Euro breakup was high in 2012 but assessed that this level of pessimism was already priced into the market so it was not reflected in our asset allocation.

“We were also overweight Australian equities in our balanced model portfolio despite the apparently poor economic fundamentals because equities were so attractively valued, a strategy which proved to be the right approach,” Mr Ramsay said.

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The same issue was alluded to in a recent Bloomberg observation that in the US bonds have beaten shares over the last 30 years. While one can quibble over the details,  given these observations it is natural to think maybe it’s time to give up on stocks and switch to cash and bonds.

Stocks do outperform over the long term
The first point to note is that over the very long term, shares have provided higher returns than cash or bonds. The next chart is the one referred to earlier and shows the total returns from Australian shares, bonds and cash from 1900. Despite numerous disasters along the way, such as World Wars, the Great Depression, the stagflation of the 1970s, the 1987 share crash, a major Australian financial crisis in the early 1990s – $1 invested in Australian shares in 1900 would have risen to $287,087 by last month with a compound return of 11.9% pa. By contrast, the compound returns of 4.6% pa and 6% pa for cash and bonds would have seen $1 invested in these assets rise to only a fraction of this.

It’s been a similar story in other comparable countries.

The long term outperformance of stocks over bonds and cash is as would be expected – the greater riskiness of shares is rewarded with higher long term returns.

The following chart shows a real accumulation index for US stocks since 1900. The trend line represents a real rate of return of 6.2% pa. Whenever the index is rising faster than the trend line, stocks are providing above trend returns. Vice versa when it falls relative to the trend line.

Long term bull & bear phases are evident, of which the bear phase over the last decade is not unusual. This pattern also exists in other countries. 

This suggests that at any point in time the experience of the past 10 to 20 years is no guide to the long term. An investor in US stocks at the end of the 1960s would have been wrong to project the above average returns of the 1960s into the 1970s (when actual real returns averaged –0.7%pa). Likewise the bad 1970s were no guide to the 1980s (when real returns averaged +11%pa).

In other words 10 to 20 years is not the long term when it comes to shares. So the fact that US shares have underperformed bonds over the last decade doesn’t mean they will over the next.

In fact, what’s evident is mean reversion. Ten to twenty year periods with above trend returns and above average returns relative to bonds and cash tend to be followed by weak 10 to 20 year periods where returns are below trend. The table below shows the top performing asset classes (out of equities, bonds, cash and property) for each decade over the past century in the case of the US, the world and Australia.

The 1982-2007 bull market in Australian shares arguably spoilt investors and we have simply forgotten that the superior long term performance of shares comes with a cost, which is that there are sometimes lengthy periods during which shares can perform poorly.

The 10 to 20 year return cycle in shares reflects fundamentals. It’s no guide to the ‘long term’.

The 10 to 20 year secular cycle in shares appears to reflect a combination of factors including:

• Starting point valuations – US share prices were high relative to trend earnings (ie the PE ratio) in 1929, the late 1960s and in early 2000 (after which followed the secular bear markets of the 1930s, 1970s and 2000s) and low in 1949 and 1982 (after which followed two decades of strong returns)
• Underlying economic developments – depression in the 1930s and inflation in the 1970s were bad for shares, whereas solid economic growth, disinflation, economic rationalism, globalisation, etc, in the 1980s and 1990s were great for shares. Right now it’s deleveraging in the private and public sectors in the US and Europe which is proving to be bad for stocks
• Technological innovation – rapid technological innovation helped push stock returns above trend in the 1920s (electricity, mass production), 1950s (petrochemicals, electronics) and 1990s (IT).

Perhaps the most important point is that the starting point matters. Ten years ago US stocks were offering a dividend yield of just 1.5%, but the 10 year bond yield was 4.6%. This made it much easier for bonds to outperform shares as indeed they have over the last decade. But it’s now going to be harder for bonds to outperform over the decade ahead as their yield has fallen to less than 2% whereas the dividend yield has increased to 2.2%. This is still low, but even if share prices do nothing over the decade ahead shares will outperform bonds.

Likewise in Australia, 10 years ago bond yields were 5.6% and dividend yields were just 4.3% so it was comparatively easy for bonds to do well. Today though bond yields are 4.2% and the grossed up dividend yield is 6.8%. In other words, it’s currently easier for shares to outperform bonds over the decade ahead as bond yields are quite low relative to dividend yields. 

This is also highlighted in Australia with the dividend yield grossed up for franking credits now running well above bank term deposit rates which are now falling. In fact, on this basis the grossed up dividend yield of 6.8% compared to term deposit rates of around 5.5% imply shares are paying out 1.3% more cash per annum than term deposits.

Concluding comments
The historical record suggests:

• over the very long term stocks do outperform most other asset classes
• however, there are 10 to 20 year periods over which this is not necessarily the case. In this context the recent experience in share markets is not unusual
• the outlook at any point in time in part depends on the starting point. After a decade or so of above average returns a period of slower returns is likely, & vice versa.

The long term cycle in equity markets should clearly be allowed for in setting investment strategy for individual investors. While 10 years might not seem long for me, it is very long for my mother. So, as discussed in a recent note, an outcome or absolute return investment approach may be appropriate for those with a short term investment horizon or specific investment needs. 

However, for those with a longer term investment horizon it’s worth bearing in mind that in an historical context the turbulence in share markets in recent years is not unusual and doesn’t tell us shares won’t provide superior long term returns going forward. This is particularly so with dividend yields on shares rising at a time when yields on bonds, cash and term deposits are falling.

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Over the past year economy-wide profits grew by just 0.4 per cent – the weakest financial year outcome in the 17-year history of the series apart from the GFC period. No wonder businesses are seeking to cut costs and are refraining from hiring new staff.

The good news, as shown by other data out today, is that inflationary pressures are contained, making it an easy job for the Reserve Bank to leave interest rate settings on hold. We expect the Reserve Bank to stay on the interest rate sidelines for the remainder of the year, providing the economy with a shot of much-needed stability.

Given all the uncertainties – whether it be the global economy, domestic politics, the proposed introduction of the carbon tax or interest rates – it is far from surprising that businesses aren’t in the mood to hire at present. In trend terms job ads have now fallen for five months in a row. The silver lining could be that productivity will start to improve as businesses focus on working their existing employees harder or more efficiently.
The sharp increase in inventories in the June quarter is good news for economic growth. However, as we’ve seen in the past, large increases in stocks tend to be unwound, raising questions about future production, employment and overall economic growth. While the mining sector arguably needed to rebuild inventories to meet higher demand, clearly the same can’t be said for most other sectors, especially wholesale and retail trade together with food services.

What are the implications for interest rates and investors?
The Reserve Bank can rest easily on the interest rate sidelines. There is no need to rush ahead with rate cuts, while rate hikes are certainly off the agenda.

CommSec has reviewed the profit performance of big listed companies. Of the ASX 200 companies producing full year accounts, aggregate profits rose by 32 per cent in 2010/11. However the mining sector (especially BHP Billiton) drove the result. The ABS series shows that smaller companies, especially those outside the mining sector, struggled to lift profits over the past year. The multi-speed nature of the economy is clearly on show with the mixed results on profits across industry sectors.

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CMC Markets has launched a new pattern recognition tool to help traders sort data, identify patterns and execute trades with ease. It is thought to be the first time in Australia that pattern recognition software has been integrated into an existing platform rather than using a third party provider.

Pattern recognition is free to all clients using CMC Market’s desktop and web based CFD platforms. Since being launched to CMC Markets’ existing clients in Australia, almost 40% of active clients have taken up the tool.

Pattern recognition is one of the most versatile skills that a trader can have and focuses on finding price patterns and using them to look for breakouts and momentum shifts across markets and timeframes. It has multiple applications and can assist clients to work out where to enter, set stop loss orders and set profit targets. It can be as advanced as complex algorithms or involve nothing more than a pencil and a ruler.
CMC Market’s new software identifies both completed and emerging patterns over short or medium time frames and ranks the quality of the chart signals based on technical indicators such as moving averages.

“One of the biggest benefits of the software is it allows traders to scan a wide variety of markets swiftly and rank them,” David Land, CMC Markets Chief Market Analyst said.

“By integrating it onto our platform, traders who already trade confidently but are currently using third party applications can now scope out simple or complex patterns then execute positions with ease,” said Mr Land.

The integrated software can also educate traders who don’t currently use technical analysis as part of their technique, with free video tutorials and an internally-written software guide.

“CMC Markets has a strong focus on education and it is important to ensure clients are equipped to use the tools effectively. The key is for traders to build their experience gradually and spend time learning the basic rules around pattern recognition,” Land said.

Once patterns have been identified, it is then up to the trader to decide whether to execute the trade. They can take long or short positions based on chart signals. In periods of volatility where markets appear to be moving sideways, identifying emerging patterns can assist in generating returns.

The software allows traders to customise the type and number of patterns that are displayed to identify trades and understand the risks associated with a position.

“We are providing our clients with a powerful, customisable piece of software and have made it as easy to use as possible. Pattern recognition is based on carefully tested methods and is another way to equip traders with the tools that are crucial for their success,” Mr Land concluded.

How pattern recognition works

CMC Markets’ integrated pattern recognition tool can follow price patterns for traders, and allows them to trade when they feel the moment is right. Triangles? Wedges? Channels? Head and shoulders? Diamonds? Each pattern has a story to tell about the direction of the market. Traders can pinpoint and overlay any pattern on any chart, and then watch it develop in real time.

Some patterns are on their way to becoming opportunities and some are already there. The tool can be used to tag emerging patterns and get an alert when the pattern is complete. If traders would like to know how previous patterns have panned out, the tool also the ability to review.

Every pattern gets a one- to five-star rating based on a range of indicators including MACD, the RSI, stochastic oscillator, 21- and 55-day period moving average, the DMI plus and DMI minus. The more stars, the stronger the signal.

In the following chart you can see the blue lines are pointing to one of the most common patterns, the symmetrical triangle. Triangles are one of the most common patterns that allow a trader to see opportunities on both the long and short side, and capture the point at which the price consolidates, allowing a trader to see where an eventual “breakout” will occur.

Seeing this chart from a normal point of view it is just a trading chart. But from a pattern recognition point of view, the blue lines form a symmetrical triangle, pointing to where a trader can pick a break out in the price.

With the new integrated platform, once they have identified a pattern, a trader has all the normal features that allow them to open an order ticket and place a trade in the normal way.

Another feature of this platform is the ability to open charts and then add patterns in real time as well as look at how these same types of patterns have performed in the past. This can be done across many different time frames to give an idea of the success of a certain type of pattern.

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