Key points

• If we get a period of stability of leadership and policy the S&P/ASX 200 could be significantly higher by Christmas particularly if that stability coincides with certainty from the Fed on US interest rates and Chinese data improving.
• Most leading Australian industrial stocks are paying investors 6.00% fully franked to hold them. Shareholders are getting paid to take the equity risk in Australia.
• A historical review of previous US rate rising cycles reveals that after an initial period of volatility, which has seen the US equities down by 5% on average, the market has risen for the next 12 months following the increase on 75% of occasions.

Over many years I have consistently written that “confidence is a derivative of leadership”.

This week has seen Australia’s fifth Prime Minister installed in as many years and I have had many questions from my fund investors about what I thought the ramifications were.

Firstly, I must say the view from overseas commentators I speak to is negative. Negative in the context of a “revolving door” of leadership breeds policy uncertainty and policy uncertainty leads to a higher sovereign risk rating being applied to a given country’s asset base.

On the other hand, the view from domestic business leaders and other investors I speak to is positive, feeling we at least now have a “businessman” leading the economy in a time of structural change.

I’m not going to enter a political debate but I think you can see these two views played out on Tuesday and Wednesday on the S&P/ASX 200. Big foreign selling on Tuesday, flowed by big local buying on Wednesday.

Finding the value

As I have written for many weeks in these notes I think there is clear and present value in Australian financials and resources at the S&P/ASX 200 index level of 5000. Quite frankly I think a good technical support base is forming on the benchmark S&P/ASX 200 Index around 5000 and my view is the new trading range, for say the rest of the year, will be 5000 to 5400. I do expect better prices as we head towards year end.

I actually used Tuesday’s heavy offshore selling to add to investments in Australia because I tend to feel there’s a good chance, not a certainty, of business and consumer confidence lifting into the end of the year.

In reality, business and consumer sentiment doesn’t have to improve, it just has to get “less worse”. I think that’s a chance under the new Prime Minister and his team. The fact the leadership change has happened at what I think is most likely the bottom of the near-term S&P/ASX 200 trading range adds to my view that sentiment only needs to get “less worse”.

Again, do not misinterpret this as a political view. Yes I know the Prime Minister and the Foreign Minister personally, but that doesn’t change the fact they have a big task in front of them to steady and turn the Australian economic ship.

As an investor and an Australian, all I really hope for is a period of stability – stability of leadership and stability of policy. If we can get that combination I would almost guarantee you that the S&P/ASX 200 will be higher by Christmas, and perhaps significantly higher if it also coincides with certainty from the Fed on US interest rates and Chinese data improving.

Negative nellies

The S&P/ASX 200 has had the “kitchen sink” of negativity thrown at it and the result has been a deep and painful correction. But if I look out a few months I can see a positive combination of events. As I wrote last week, bank capital raisings have finished, commodity prices appear to have bottomed in Australian dollar terms, employment is actually okay, house prices are hanging in, bank dividends will be paid in Oct/Nov and the offshore tone may also improve. It also coincides with the seasonally strong period in global equities.

So I am in the “what could go right camp?” from here and I think that is the question ALL investors should ask themselves after a correction. Perhaps we will look back and the change of PM was one step in the “right” direction. I will laugh if the market did bottom the day he was sworn in.

More fundamentally there is deep value in Australian equities and I believe there are catalysts for that value to be released in the weeks and months ahead. I like that most leading Australian industrial stocks are paying me 6.00% fully franked to hold them. We are getting paid to take the equity risk in Australia and I for one am taking it.

Headlines fade in this world of Twitter. “Grexit” and “iron ore” have all but disappeared, now the headlines are “China” and the “Fed” which too will disappear in time. Quite frankly if you bought equities every time “crisis” was trending on Twitter you’d be very, very rich.

Markets price the present. That is all they do. My job, and your job as an investor is to take advantage of the present and visualise the future. Once you visualise the future you should set your portfolio to match that visualisation. I need to accurately forecast the Twitter headlines of three, six, 12 and 18 months from now in this world of instant everything and markets priced by high frequency traders. I’d prefer to be a low frequency investor.

Low frequency investing

The markets right now are giving you are chance to be a low frequency investor. They are giving you a chance to set a high quality portfolio for the next few years. That is true domestically and globally. That is what I am trying to do with my fund: build a high class domestic and global portfolio that will perform over the next few years.

That includes in the US where I am not afraid of the first Fed rate rise in 9 years. I don’t know if that rate rise will come this month, next month or December. My point is, it is a “known known” in terms of being telegraphed to markets and I believe markets are pricing it in.

A review of previous US rate rising cycles reveals that after an initial period of volatility, which has seen the US equities down by 5% on average, the market has risen for the next 12 months on 75% of occasions. There has been three such cycles since 1994. In that year the S&P had a 9% correction after the first rate rise only to rally 16% the next year.

In 1999 the SP 500 rose 6% over the next few months. In 2004, following a 7% fall, the market was up 20% over the next year. This fits well with history given that a Fed rate raise would be consistent with the strongest three-monthly period for US equity monthly outperformance. Since 1950, Citigroup reveals that the three-monthly performance from October has averaged 4% while from November it’s been 4.3%. Against this positive backdrop, the American Intelligence Survey, the benchmark for investor sentiment, is at its lowest level since 2008. In addition, cash levels are high. So the risk is to be under-invested in US equities. As Peter said on Monday this could be a real sell the rumour buy the fact event. The key for me this time is the US equity market has already had a correction, unlike the previous three cycles.

Interesting also is Vanda research detailing the outperformance of cyclicals under a US rate tightening cycle. Long trade is US industrials, banks and materials and long EU banks and emerging markets. Similarly, given the extreme pessimism to everything China-facing, others are promoting the China mean reversion trade with a view to looking at commodity related plays and emerging markets. I think we basically agree with this scenario and we are positioned for a resource rally and EU performance through the DAX. In this respect, the DAX was up last night Good data from Germany recently – stronger PMI, growth and export data – supports our long DAX view.

All in all I remain of the view that it’s time to be constructive and invested in global and domestic equities. Yes, there will be bouts of short-term volatility as the world trades every “Twitter” headline, but to me these are opportunities to increase exposure to high quality equity investments.

I’ll be on Peter’s show on Monday night and to expand on these views.

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