Now, one of the truest truism’s in financial markets is the saying that not everyone can be right at the same time. The reason is that if everyone has the same opinion, and has entered into the same trade in anticipation of that opinion playing out, then no-one is left to ‘buy’ or ‘sell’ to deliver the outcome that is the expected by the consensus opinion. This is what is meant by the phrase ‘the market has priced it in’.

But just occasionally, this rule is broken – most usually because people have not acted on the strength of their convictions.

The question then is whether the universal pessimism is baked into market prices – and if so, does this prohibit consensus actually unfolding.

Let’s quickly summarise the state of play – it’s pretty easy to paint the bearish picture:

1) Global leading indicators suggest we are heading into a synchronised slowdown in economic growth with possibly a double-dip for emerging economies like Brazil and India, and reasonable odds that the US and Europe will follow. The jury remains out on China – with its property development sector likely to falter and local governments loans being hived off bank balance sheets the signs aren’t great, but it’s a command economy and can put the foot back on the accelerator in short order.

2) Australia is in a difficult position. On the one hand planned capital investment is historically huge and coal and iron ore exports remain very strong – but unless you work in the sector, or own the resource, the benefit of this plunder is questionable. The main way that the Australian economy benefits is through the tax take – and that money has already been spent. So the bulk of the Australian economy by headcount at least is struggling under the weight of excessive debt, high interest rates and rising consumer prices. This is why residential property is turning up its overhyped toes and why retail sales have dried up.

3) With equity markets having enjoyed the global re-rating of risk and now looking weak at the knees, no wonder fund managers are feeling a little queasy about the outlook.

So we get to the crux of the issue. Have portfolio managers acted on their sense of imminent doom? If we had access to some meaty data on portfolio flows, we could have a real stab at answering that (it’s something being worked on). So the simplest proxy to get a feel for the answer is by looking at relative sector performance:

What we are looking at here is the 50 day moving average for indices for Consumer Staples (XSJ), Materials (XMJ) and Financials (XXJ). If fund managers had been rotating out of risk and into defensive stocks then consumer staples would outperform – and perhaps at the margin this has been the case since the most recent wobbles began back in March. But it certainly doesn’t look like a fully fledged exit. (We’ll come back to the performance of the financials in another post.)

Another way to look at this possible sector rotation is in the following charts that look at relative performance in a longer term context:

Notably, the more defensive consumer staples sector has been outperforming both the small cap and discretionary sector since March. So this would seem to confirm the trend. But for mine if we were to really be seeing an exit from the risk trade it would show up in a flight from the resources sector – and to date, this is just not really happening.

Conclusion – while fund managers may be very pessimistic about the outlook, it does not look likely that these opinions have been ‘priced it in’. This’d be consistent with my colleague’s reply when asked, “Are portfolio managers underweight risk then?” …”I don’t think so.”

It’s not been a great sign of strength for the global equity markets that indexes like the All Ordinaries, Canada’s TSE and the Russell have not joined the S&P at new highs.  Well let’s see what is happening in the bowels of the Australian market to see how this has come about.

First up, the strongest index in the Australian market – XMJ – the materials where the miners reside:

Nothing but uptrend here.  It has just pushed through a 50% retracement of its entire downdraft.  No signs of weakness here.  If the All Ords was just miners we would indeed be at new highs for the year.

So what the hell is happening with energy (XEJ) then?

It topped nigh on 6 weeks ago.  The MACD has crossed over, volume is spiking higher on down days/weeks.  This index is not the picture of health.  But maybe that is sector specific – plenty of analysts have been downgrading their oil price forecasts recently as they ratchet back demand assumptions while increasing inventories.

On the other hand, the small caps are not looking to flash either (XSO):

At least it has tried to retake its highs.  But a failure at the recent highs with the MACD also spilling over has this index on the tightrope without one of those long poles (any tightrope walkers out there know the technical name for it?).  It is one index that needs to break higher soon – it surely won’t recover so quickly from a second breakdown through its uptrend.

Of most concern are the financials (XXJ):

This index also peaked 6 weeks ago.  Given it is a heavyweight in the XJO – it is the primary reason for our market failing to push to new highs.  Note the MACD has crossed over, momentum has broken to new lows, and volume has been heavy into the weakness.

Conclusion:

If broader market weakness sets in, it’ll be lead by a breakdown in the financials, but will need materials and energy to follow suit.  In the absence of a catalyst, hard to imagine that the market will simply collapse under its own weight.  But I guess stranger things have happened.