Ride the waves but be careful of the third one

Photo of Alan Hull, author By Alan Hull, author

min read

What the charts say about shares in Australia, US, UK and China.

In the late 1800s Charles Dow of the Wall Street Journal observed that the sharemarket tended to move up in a sequence of three rallies, or waves as he called them. At the end of the third wave it was time to sell your stocks and wait for the inevitable correction.

Then in the early to mid-1900s Ralph Elliott, creator of the Elliott Wave theory, attempted to quantify Dow’s observation and give an explanation as to the underlying psychology of each wave.

Thus, the first wave is driven by bargain hunters and early converters. These are the investors who are watching stock valuations rather than prices and will buy into the market when they see good companies being beaten down too far. They have little fear of negative sentiment as they rely exclusively on fundamentals. Warren Buffett is in this category.

But once this phase is over, the market will get sold back as most investors remain afraid of stocks; the recent correction will still be fresh in their minds.

Then the second bullish wave will commence as the companies’ fundamentals start to shine through and the economic outlook improves. Fear dissipates and the bulk of investors return to the market.

The second wave is the most broadly prescribed and will typically be the most dominant time during a bull run. And because this period is largely driven by fundamentals, it begins to weaken as prices rise to the point where the fundamentals become stretched. Value investors will start to take their leave of the market and the second bullish wave will come to an end and the market will correct once again.

At this point we have undergone two bullish waves, tested the upper limits of the market’s fundamentals and are collectively wondering: where to from here? But then a strange thing happens as new investors begin to catch on to the idea of rising share prices and for no sound reason start buying shares, simply because they are going up.

This is the start of the third wave and is appropriately called the ‘lemmings phase’, where share price movements part with sound logic. Companies are valued more on future earnings than current figures, and those paying high dividends are priced on their yield rather than fundamental valuations. You start to hear things like “this time it’s different” and taxi drivers start to give stock tips. It used to be the shoe-shine boys in the 1920s.

Although I haven’t received a stock tip from a taxi driver since 2007, markets around the world are all trading at premium price-to-earnings ratios - and I keep hearing that this time it is different because of record low interest rates. Hence higher share prices are being justified because investors are happy with any dividend that beats fixed-interest investments.

When I look at the charts, it’s as if Charles and Ralph are right there with me, whispering “It’s the start of the third wave.” The following chart of the S&P 500 index from the United States is a mixture of leading stocks from both the New York Stock Exchange and Nasdaq markets, a monthly chart that goes back to the 2008 global financial crisis.

A chart like this shows a clear picture of what’s happening because all the short-term noise tends to disappear on monthly charts. A red trendline identifies the current bull run and two blue lines show the first two waves. I believe US markets are just beginning their third wave.

This fits well with the current circumstances, where the social media boom has carried the likes of Twitter and Facebook to price levels that simply are not justified by their current fundamentals.

Furthermore, I think Donald Trump’s Administration, combined with Republican control of the Senate, will enjoy a honeymoon period in 2017. Thus, despite it being the Asian Century, the US will be the key driving force behind the global economy in 2017.

I see a similar pattern in the monthly chart of the London FTSE 100 index, albeit a bit more subdued. This market is more conservative than those in the US but it also appears to have begun its third wave.

In Asia, the chart of the Shanghai Composite index does not show any obvious wave pattern, but Asia does run to the beat of a slightly different drum than Western sharemarkets. I have placed a red trendline under the most recent index activity.

You may recall that the Shanghai market enjoyed an exponential rally across 2014 and 2015, and like all exponential rallies it suffered a sharp correction – a polite way of saying it crashed. It has since arrested its decline and begun to rise again, albeit far more subdued than last time.

The key thing to note is that the Shanghai Composite does not normally boom then bust and then boom straight away again. It booms then busts, then rests, then booms again. Note the preceding period on the chart of the Shanghai, from 2009 through to 2013, where the Shanghai Composite had a nice long break after the GFC.

Although the Shanghai may continue to rise slowly as it is now, I would not expect it to blast off again anytime soon. Reiterating my earlier assessment: the US will be the key driving force for the global economy in 2017. That said, the red trendline in the above chart denotes a period where the Shanghai rose by more than 50 per cent, so it certainly is not a drag on the rest of the world.

In the Australian sharemarket, the All Ordinaries index is not dissimilar to the chart of the FTSE 100 index. It’s easy to identify the first two waves and like the US and London, the All Ordinaries appears to be in the early stages of wave three.

The common feature across these charts is they have been rising since the low of March 2009. Thus, each market has participated in the current bull run, with the US at its epicentre, and I think this is exactly how things are going to play out to the end – the US leading other world markets higher through the third wave.

2017 will be a good year for investors but I have a couple of caveats. It will not be a period where fundamentals are a good guide, and you will do better to simply follow the crowd and buy popular rising sectors and stocks. Enjoy the ride but beware of what comes after the third wave.

About the author

Alan Hull is one of Australia's leading sharemarket experts. To enroll in one of his free online courses, visit his website.

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