The market has undergone a major adjustment in the last little while. Some saw it as a market correction and the demise of the high-yield play. I see it as a time to get set with a little more confidence than normal. The backdrop for this posting is that it looks like our financial year forecast for 2015/16 might leave us just under 6500 in June 2016!

Regular readers will know I measure mispricing for each of the 11 major sectors of the ASX/S&P 200 and the broader index. I call this mispricing ‘exuberance’ and it is a measure of how far the sector prices are from my estimate of fair value. Experience has shown that when a sector or the market is more than 6% overpriced, it is so expensive that a correction or prolonged sideways movement is foreshadowed.

Exuberance measures

In Chart 1, I show my exuberance measure at two points in time: March 1 (blue bars) and May 18 (red bars). The four high-yield sectors (financials, property, telcos and utilities) were all in correction territory (above the black dotted line) on March 1 – as was the defensive (but low yield) sector, health.

Chart 1: Mispricing on the ASX 200 at two points in time

Source: Woodhall Investment Research

On March 1, two sectors (energy and staples) were quite cheap. Information technology was about fair price. Nearly three months later, no sector was more than a little overpriced. It is unwise to buy a stock or sector that one believes is very overpriced – even if there appears to be an attractive yield at hand. A quick snap back in price – as happened with the big banks – can erode a whole year’s yield or more in a few days. Of course, investors who bought before the bubble can ignore the market gyrations. Unrealised capital gains and losses are just that – unrealised.

The financial sector

In Chart 2, I focus just on the financial sector’s price index and exuberance over the current financial year. Instead of using a simple line chart to show how the price index evolved over the financial year, I have colour-coded it to show exuberance and price in the same chart – a sort of 3-D effect. The red dots signify correction territory above the ‘magic 6%’ line in Chart 1. The blue dots represent a bargain – or significant negative mispricing (other conditions being satisfied as I write about on my website). The other colours fill the spectrum of mispricing. I would not buy in red or yellow territory. I am sorely tempted in green and blue. I might buy in the black if I have other good reasons.

Chart 2: Price index and exuberance in the Financials sector over time

Source: Woodhall Investment Research

What I see in Chart 2 is the sector was trading sideways with many buying opportunities. At the start of February, the price index grew aggressively (in yellow) and stayed in the red zone for over two months. This was a period when investors were chasing yield too aggressively after the February cut in the RBA rate. Eventually, the bubble had to pop and it did so quickly. Interestingly, the index turned blue just after the second rate cut – possibly because the RBA did not give an outlook statement making future rate cuts seemingly less likely. As it happens, the index is now just about where it was before the February rate cut.

It is important – at least in my opinion – to appreciate that we are at a reasonably unusual point in the market cycle. In Chart 3, I have calculated the average exuberance across the 11 sectors without reference to the sign. That is, the average absolute value of +2% and 2% is +2% (rather than the ‘usual’ average of 0%). This absolute measure gives a good idea of how balanced the market is.

Chart 3: Average absolute exuberance across sector

Source: Woodhall Investment Research

While the current level of the index in Chart 3 is not at the lowest – it is pretty close to it. In my opinion, this supports getting back into the market in general – or the high-yield sectors, if that is what an investor wishes.

Sector forecasts

In Table 1, I show my current forecasts for each sector and the index. Property is probably the weakest sector at this point in time but financials, with a yield back above 5% (plus franking credits) and a forecast capital gain over the next 12 months of 9% looks tasty. Of course, the diversification principles I discussed in my posting last month are just as relevant now. This table just makes me feel content about being in the market – or getting in if I wasn’t already set.

Table 1: 12-month-ahead sector forecasts of yield and capital gains

Source: Woodhall Investment Research

By the way, some readers might remember I got bullish on Cochlear when it was in the low $50’s a couple of years or so ago. Not many agreed with me at the time but I sold most of what I bought then in the low $50s at an average of above $80 with some as high as $91! I still have a small holding in Cochlear and I am prepared to get in deeper again when I think the time is right. I took profits and risk off the table for a breather.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.