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This article appeared in the March 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Several contrarian indicators suggest a stronger sharemarket this year.

Photo of Gary Stone By Gary Stone, Share Wealth Systems

It is no secret that the Australian sharemarket, as measured by the S&P/ASX 200 index or All Ordinaries index, is lagging other international sharemarkets. A bear market feeling is rife among Australian investors who are pessimistic about shares.

Markets do not go up forever, nor down or sideways forever. Trends change. This article looks at what signs can signal an impending change in sentiment, in either direction, in the Australian sharemarket. Investors should look at these signs on a monthly basis.

The level of commitment of retail investors to the sharemarket is a good contrarian indicator. Many retail investors get it wrong in bull and bear markets. Most are inactive in shares and are selling longer-term positions near the bottom of a market cycle and most are buying and very active at the top of a market cycle. They buy when they should sell, and sell when they should buy. (Editor's note: History shows that bull markets sometimes start when small investors have deserted the market).

The level of activity by retail investors in the Australian sharemarket is at a record low. Hence, as a contrarian indicator, this inactivity points to a potential share rally.

Another contrarian indicator is the level of investment in bank term deposits, which are at an all-time peak. In July 2007 term deposits in Australia totalled $207 billion and that more than doubled to $438 billion in December 2011, as more investors fled the sharemarket and sought less volatility and risk.

Managed funds' net cash flows in the United States are another contrarian indicator. From May to December 2011 there were eight consecutive months of net outflows from equity mutual funds. (Editor's note: this means investors were selling their units in managed funds that invest in shares).

In the 20 years since January 1992 there have been two previous periods of seven consecutive months of net outflow from US mutual funds, but never eight, which indicates the extreme negative feeling towards shares in the US during 2011. But January 2012 was a month of net cash inflow (investors start buying equity managed funds again) and halted the eight-month streak of outflows. February looks like being another net inflow month, potentially signalling a change to a more positive sentiment.

Other contrarian indicators, the Baltic Dry Index and the Harpex Shipping Index, are at all-time lows. These are indicators of dry commodity shipment and of finished goods, respectively, and hence of economic expansion growth around the world (higher global economic growth usually means greater demand for ship, to move goods). Although both these indices may have been skewed over the past two or three years by an oversupply of ships, they still have validity. Being at all-time lows, these could be contrarian indicators of a potential turnaround.

Market breadth signs

A key market breadth indicator for the US equities market, among others, is the New York Stock Exchange Cumulative New Highs-New Lows index, shown below. With the US typically being a leader for sharemarkets around the world, this breadth indicator (which is based the number of stocks moving up, to those moving down) can be used as a breadth indicator for all markets, including Australia.

This NYSE index started turning up in October 2011 after a three-month decline but only crossed above its 40-day moving average (pink line) in early December.

New York Stock Exchange Cumulative New highs-New lows index - 2009 to 2012

New York Stock Exchange Cumulative New Highs-New Lows index - 2009 to 2012
Source: Beyond Charts

Since then, in January 2012, the Nasdaq (and AMEX) Cumulative New Highs-New Lows indices have also turned up and crossed their 40-day moving averages, confirming the NYSE index cross in the chart above.

Breadth indicators are not used for short-term market timing as they are delayed, but can indicate bigger trend changes that last for months.  (Editor's note: simply put, the breadth indicator is showing that more stocks are participating in the rally in US shares, which is a good sign).

Inter-market indicators

There are a number of big-picture inter-market indicators that can warn of impending changes in sentiment. The first is analysing the inter-market relationship between shares and commodities. This is done as a ratio, or conducting what is called relative strength comparative (RSC) analysis between shares and commodities. When shares are outperforming commodities, shares indices tend to rise, and when commodities are outperforming shares, share indices tend to fall.

The 30-year weekly chart below depicts the All Ordinaries index in the top section, the RSC (ratio) between the All Ordinaries and the Continuous Commodities Index (CCI) in the middle, and a 52-week smoothed momentum indicator (SIROC) of the RSC, in the bottom section.

All Ordinaries Index 30 year weekly chart

All Ordinaries Index 30 year weekly chart
Source: Beyond Charts

The middle graph shows the ratio between shares and commodities. When the middle blue line is rising, shares are outperforming commodities, and vice versa.

Although not perfect (nothing is in investing) there is a close correlation between the peaks in the bottom graph and the peaks of the All Ordinaries index, and the troughs in the bottom graph and the troughs of the All Ordinaries index, as matched by the red and green vertical lines.

Indeed, by turning down, the indicator warned of the following bear markets: 1987 (momentum indicator was 'overbought' for many months), 1989-90, 1992, 1994, 2002 and 2008.

The following bull markets were signalled by a turn up in the momentum indicator, similar to what is occurring now: 1983, 1985, 1991, 1993, 1995-1999, 2003, 2006, and 2009 and potentially this market.

The latest turn up at the righthand edge of the bottom graph that started in early November 2011 is potentially signalling the start of a rally in Australian shares.

The other two inter-market analyses that can be used are the ratios between Australian shares and the Australian 10-year bond, and shares and the Australian dollar. The All Ordinaries to 10-year bond ratio is showing a similar turn up as the chart above. The All Ordinaries to Australian dollar ratio is in an "oversold" area where equities bull runs start from, indicating that Australian shares are oversold relative to the Australian dollar.

The same timing works on these three ratios with US shares and hence other international sharemarket indices. All three of these ratios are showing positive signs for a share rally, where US shares have recently started outperforming commodities, bonds and the US dollar index, indicating a potential change in sentiment to shares in all international markets.

Equity indices

Another indicator to analyse is sharemarket indices. There are three groups we can analyse:

  • International shares indices
  • Australian defensive sector indices
  • Australian small and mid-cap indices.

US shares indices are all in uptrends. The Dow Jones Industrial Average, S&P 500 and Nasdaq Composite indices all bottomed in early October 2011 and have since risen 21.7 per cent, 23.9 per cent and 26.2 per cent, respectively, from their October lows to February 21.

All three indices are well into uptrends, their respective 200-day moving averages all rising and positioned above their 40-day moving averages. The Nasdaq Composite reached an 11-year high in early February and the DJIA a 45-month high only last week. In the short term there could be a retracement, given these rises without a breather.

The FT100 index in the UK and DAX indices in Germany are following suit but do not yet have rising 200-day moving averages. However, they have both crossed above their 40-day moving averages and are also positioned well above important Fibonacci retracement levels.

My verdict is that international indices are all rising and are in fairly well-established medium-term uptrends. It would be unusual for the Australian sharemarket to totally ignore a decent share rally in overseas markets.

Local sharemarket sectors

The main defensive sectors on ASX are consumer staples, health and Australian real estate investment trusts (A-REITs). The consumer staples and health sectors have been underperforming the All Ordinaries since the third week of December, and the A-REIT sector is matching to slightly underperforming the All Ords. This indicates that investment capital has been shifting from defensive sectors to those with stronger growth prospects.

It might come as a surprise, but the big winner has been the telecommunications sector, and the industrials and utilities sectors have also gained against the All Ords.

The last step of our analysis of the small and mid-cap sectors shows that the strongest moving since early January 2012 has been the Small Industrials index, helping the Small Ordinaries to also outperform the All Ordinaries. It is considered that small-cap shares lag when market sentiment changes, but research shows that some of the best market runs are led by small caps outperforming the broader index.

In summary, there is no doubt that the signs are there of a change to positive sentiment towards shares. There are no guarantees in investing but there is also no excuse for inaction.

Statistical bear market analysis

Lastly, some quantitative analysis of bear markets in the US and Australia and their ensuing bull markets. These tables were first shown in ASX Investor Update in March 2009, just before the last major equities bull market.

Although these tables should not be used for timing the market, they can be used as an indication of ensuing rises following a bear-market bottom. US markets have already risen more than 20 per cent and the All Ordinaries just 9 per cent from their October 2011 troughs, so there is more room for further rises in equity markets.

Dow Jones Industrial Average

Date Market Fall Length in months Market Rise Length in months Shape of bottom
1901-1903 -45% 28 143% 26 V
1906 - 1907 -49% 22 92% 24 V
1916 -39% 6 50% 17 V
1919 - 1921 -44% 21 62% 18 V
1929 - 1932 -89% 34 97% 2 V
3/1937 - 4/1938 -49% 13 61% 7 V
9/1939 - 6/1940 -29% 9 24% 5 V
11/1940 - 5/1942 -32% 18 127% 40 V
5/1946 - 11/1946 -24% 6 14% 3 Non-V
11/1961 - 6/1962 -29% 7 90% 43 V
2/1966 - 10/1996 -28% 8 35% 26 V
12/1968 - 5/1970 -36% 18 52% 11 V
1/1973 - 12/1974 -45% 22 80% 21 V
10/1976 - 3/1978 -28% 17 25% 6 V
 5/1981 - 8/1982  -25% 15  68%  16 
8/1987 - 8/1987 -41% 2 28% 3 Non-V
75% 26
7/1991 - 10/1991 -23% 3 29% 5 V
7/1998 - 10/1998 -21% 2 53% 12 V
1/2000 - 10/2002 -39% 33 49% 16 V
97% 60
10/2007 - 3/2009 -54% 17 95% 26 V
5/2011 - 10/2011 -19.2% 6 ? ? Non-V
-38% 14.6 68% 19.5%

All-Ords Average

Date Market Fall Length in months Market Rise Length in months Shape of bottom
9/1960 - 11/1960 -23% 2 12% 12 V
2/1964 - 6/1965 -20% 16 98% 35 Non-V
1/1970 - 11/1971 -39% 22 52% 12 V
1/1973 - 9/1974 -59% 20 77% 33 V
4/1981 - 7/1982 -40% 15 78% 18 Non-V
8/1987 - 10/1987 -50% 2 44% 9 Non-V
  54% 22  
10/1989 - 1/1991 -33% 17 41%  9 V
5/1992 -11/1992 -20% 6 73% 15 V
2/1994 - 10/1994 -23% 10 28% 15 Non-V
9/1997 - 10/1997 -20% 1 31% 6 V
3/2002 - 3/2003 -22% 12 59% 24 V
11/2007 -  3/2009 -55% 16 61% 13 V
04/2011 - 10/2011 -22%  6 ?  ? Non-V
-33% 11.2 55% 16.8%

About the author

Gary Stone founded Share Wealth Systems (formerly ShareFinder) in 1995 and is the designer of three commercially available investment methodologies for active investors. He is a trader and continues to research the markets. He has been a regular panelist on SKY News Business Channel's 'Your Money Your Call' and 'Switzer' since 2008, a regular presenter at conferences, and has written many articles for magazines and journals since 1997. Visit Share Wealth Systems to receive FREE weekly International and Australian market and sector risk updates.

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