With the substantial rally at the start of April from 6750 to 7050, the market stayed in an overbought state for almost the entire month of April.
The market as it currently stands continues to show strong oversold momentum, making it difficult to go long in the current conditions.
The rally in April was driven by a resurgence in the growth (Information Technology) sector without a rotation out of value sectors such as banks.
In that period, the Information Technology sector rallied from 1925 to 2250.
The surge I believe was attributed to the flattening of the bond market and settling of yields – a fact that drove down the growth sector from February to March.
This has caused the market to break out of the 6650 – 6950 band which it traded in for a good 3 months.
What’s interesting to note is that the same rally has now fizzled, with the Information Technology sector back trading towards the lower end of the range, at 1956.
The overall market, however, continues to trade above 7000 even with the drop in growth.
This is attributed to the strength in both resources and the banks.
The strength we are seeing in these sectors is due to fears of inflation as we are now seeing lagging economic indicators such as CPI showing inflation is coming into the system.
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Is the inflation transitory or here to stay?
I believe that inflation fears are misplaced and that the spike in inflation is transitory.
This is because the rise in the cost of materials and so forth is driven by supply restraints due to COVID restrictions around the world.
Consumer demand has risen due to pent up demand but this is also transitory. Once you have gone and splurged on a new TV and car, it is unlikely you will do that again next year.
Supply restraints due to restrictions can be solved by simply removing the bottleneck, whilst demand is much harder to solve because it requires higher wage growth which we don’t have.
Inflation at the moment is mainly a US issue with their huge cash splashes in the past year.
Even though there will be repercussions for Australia in a highly interconnected and globalised world, we have been (relatively) a lot more sensible when it comes to fiscal policy.
One caveat to my view, however, is that it is possible we will have elevated material prices for a while.
This is because governments around the world are using large infrastructure projects to boost their GDP.
Whether that translates to higher wage growth and a permanent rise in demand for Australia, I don’t think this will be the case.
Taking the latest spaghetti motorways that have bored their across and under greater Sydney into consideration, we still haven’t seen wage growth even with these major projects in play.
I am wary whether any new projects will truly stoke inflation enough to push wage growth.
Likelihood of a correction
The likelihood of a major correction right now is unlikely.
I am seeing some signs of weakness in the market such as a rally in gold and bonds usually indicative of a risk-off attitude in the markets.
Betashares Gold Bullion ETF (ASX XAU)
However, I think this has more to do with inflation fears and the unprecedented amount of money floating around in the world.
Whenever there is a very large amount of stimulus, assets tend to correlate positively to 1 because cheap money has to go somewhere and it tends to go everywhere.
Equities, bonds, gold, property, art and these days, cryptocurrencies.
Another indicator I am seeing is a steady rise in volatility, after hitting lows of below 10 we are back to levels between 11 to 12, indicating some hedging by market participants.
ASX200 Volatility Index (ASX VIX)
ASX200 Market Forecast
Right now, I am cautiously optimistic. I expect healthy pullbacks to happen but a major correction of more than 10% is unlikely in the current market environment.
I think the market will have a tough time breaking 7,200 points (an all-time high) and we will set a new trading range of around 7100 and 6950.
However, I would not be surprised if the market continues to slowly grind up towards 7,200 as the inflation story is far from over.
Expect pullbacks to be quick and violent, coming from specific catalysts such as COVID issues, central bank musings and government policy.
