Why This Market Is Going Nowhere

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Since bottoming in mid-February, the ASX 200 has rallied by around 12%. It’s nearly back to even for the year!

You can thank China for the rebound. Most of the gains have come from the resources sector.

BHP is up 50% from its lows. RIO is up nearly 45%. Fortescue, the highly leveraged, pure iron ore player, is up an incredible 150% from its late January low.

What can I say, thank goodness for China and its desperate need to stabilise its economy! It is well known that China launched targeted stimulus policies at the end of last year —that began showing up in greater activity in early 2016.

The iron ore price certainly had an inkling of what was coming. It bottomed back in December 2015.

The market, in its wisdom, saw the increased need for iron ore to feed the steel mills, the prime beneficiaries of the forthcoming stimulus.

And, sure enough, the market was right. Despite pledging to cut steel production, China is actually increasing it. From Reuters:

Under pressure to curb steel output and relieve a global glut, China said on Tuesday its production actually hit a record high last month as rising prices, and profits, encouraged mills that had been shut or suspended to resume production.

The China Iron & Steel Association (CISA) said March steel production hit 70.65 million tonnes, amounting to 834 million tonnes on an annualized basis. Traders and analysts predicted more increases in April and May.

That’s the reason for the rocketing iron ore price. Yesterday, it surged to almost $70 a tonne, the highest level in nearly a year.

We’ve seen this play out before. Back in 2012, when the Chinese government unleashed a major stimulus program, the iron ore price rallied from just above US$100 a tonne, to around US$150 a tonne.

But, of course, the price rise was always going to be unsustainable. That’s the problem with stimulus…it has a limited shelf life.

How long? Well, if the iron ore price saw the uplift in steel production coming back in December last year, it will see the inevitable drop off when the stimulus measures start to wane.

So keep a close eye on the iron ore price. Right now it’s signalling continued strength in steel production. Given the strength of the rally (nearly 100% from the lows!) I don’t think it has much left in the tank.

Lending weight to the view, I noticed this fate-tempter from the Financial Review yesterday:

Here’s a question for the big global investors who used Australian stocks as a proxy for their bets on a Chinese slowdown: How’s that big short treating you now?


Whenever the mainstream media feels confident enough to mock a group of investors who made a bet seemingly gone wrong, it’s time to worry that the rally might be over.

Did we see the first signs of that happening last night?

US stocks fell around 0.5%, while oil was down around 2.2%. No big deal but, as I’ve mentioned this week, US stocks are now pushing up against all-time highs.

Global central banks managed to engineer a strong rally off the February lows. But now it’s up to the market to push stocks to new highs. Without evidence of a pick-up in corporate earnings, or renewed economic strength, I just can’t see that happening.

The prudent way to play the current market is to anticipate prices going nowhere over the long term, but displaying a lot of volatility in the short term.

The first few months of the year have proven to be a good analogy for this. That is, stocks had the worst start to a year EVER…and then had a massive rally. They’re now back to where they started.

There’s an arm wrestle going on between the natural forces of mean reversion and the desire of central banks to avert investor panic by propping up markets.

At the end of last year, the biggest risk for global markets was the US Federal Reserve tightening monetary policy. That put upward pressure on the US dollar which, in turn, put pressure on the Chinese yuan (via the currency peg).

The Fed realised this was an issue and has, in recent months, completely pulled back from its ‘tightening rhetoric’.

You can see the effect of this in the chart below. It shows the US dollar index over the past few years. Note how since the start of this year, the index has weakened…

Source: Market Analyst

[click to open in new window]

This is effectively a release of a pressure value. It’s a big part of the reason behind the global stock rally.

Having said that, the dollar index is still trading within its longer term range. For this reason, you’ll probably see some buying support soon, which will take the wind out of the recent commodities rally.

The bottom line: don’t expect markets to trend in any one direction for long. We’re stuck in a no man’s land of poor economic fundamentals resulting from too much debt, combined with determined policymakers maintaining high asset prices.

As I result, I don’t see markets shooting higher. Nor do I see a collapse on the horizon. I see boring, trendless markets that will confound many investors as long held strategies no longer work.

You’re already seeing the fallout from this in the hedge fund industry. The post QE era saw a proliferation of high fee charging hedge funds getting their snouts in the trough.

The bull market made it easy for them to justify their fees. But, for the past year, it’s been tough going. In the first quarter of this year, hedge funds suffered the worst outflows since the financial crisis.

We might not get a market collapse anytime soon, but this market will still grind many into the ground.


Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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