Getting technical on equities: thoughts on the global rally

There are diverging views on the correct response to the recent 60-100% rally in global equity markets. Some will say that stocks are overvalued and that current buyers are simply buying because there is good upward momentum. They would add that the raft of analysts and strategists who aid this momentum are not a good sign, as they can always tweak their models to produce higher and higher prices for stocks and markets. Finally, they would point to the actions of less sophisticated investors - many of them are understandably lamenting the missed opportunity of being out of the market when prices were lower and are now reluctantly investing. Similarly, the industry's asset allocators, who are notoriously bad at timing the market, are only now sharpening their pencils over investing more heavily in equities.

However, technical analysts, who study market trends, will heed all the above but simply say that the equities are trending up and the correct approach is to follow the trend. In general, they advise waiting for momentum to turn before buying and then staying largely invested until the market breaks down. The technicals would have advised going short (looking to benefit from possible future share price falls) in November 2007 with the FTSE at a high of 6400, and then advised going long (buying) in July 2009 when the FTSE was at a low of 4100, staying invested up to now. Using a Beta of -1 or 1 (a measure of market exposure), an investor would have made 36% first shorting the index and then another 37% from being long until the present day. That's a return of 89% versus a return of -10% from being fully invested over that time.

The above is a powerful argument for technical analysis. The hardest part is being disciplined in holding your position when market volatility gets extreme or waiting for the ‘technical signal' when the position is not working. For instance, if one came into the market now and bought at 5800, as technicals would advise, but subsequently the market dropped back to 5000 over the next six months, at that point it is likely a sell signal would be suggested and one would be down 15-20% due to the unfortunate timing.

Looking at fundamentals rather than technicals my current thesis is that, with huge bond issuance from highly indebted countries the yield (annual rate of return) on bonds will rise. This is bad for bonds but will also be bad for equities on a relative basis and on an absolute basis in interest rate sensitive sectors. It is also possible that the inflationary measures that we are seeing in global monetary policy are leading to higher asset prices across markets, and creating asset bubbles. This could apply particularly in emerging economies and commodities, which could give rise to further pain for equity investors in the future. The key question is when will these issues become enough of a worry to end the current upward trend in equities? Market trends nearly always last for longer than people expect and given this, equities could move higher from here. On the absolute return fund, I have moved to a net long position and am awaiting a better opportunity to move net short.