36% Potential Upside for Australian Stocks Over the Next Two Years

There’s something exciting about a volatile market.

One day as stocks rise, the bulls can shout down the bears: ‘See, we told you!’

The next day as stocks fall, the bears can shout down the bulls: ‘See, we told you!’

It’s a darn sight more exciting than the boring but inexorable climb we saw from November through to January.

But what we like most of all about the current volatile market is seeing other investors get over-excited and ignore the market’s clear message – that stocks aren’t going anywhere fast for the rest of this year…

OK, we could be wrong.

No one can predict the market’s future moves with 100% accuracy. But forming an opinion on the market’s direction and then betting on it is a key part of investing.

Of course, most investors don’t put in half the effort we do. They don’t have the time. We’ve got 8, 10 or 12 hours per day to think about investing (plus a few extra hours at the weekend if we’re writing our monthly issue of Australian Small-Cap Investigator).

And if you’ve paid any attention to Money Morning over the past few months you’ll know we’ve had a simple – very simple – theory about how the market will move this year.

Trading the Stock Market’s Holding Pattern

So far, it’s all going to plan. The chart below sums things up neatly:

You’ll notice that we haven’t drawn the line right at the peak or trough of the range. There’s a simple reason for that. We’re a big fan of technical analyst, Murray Dawes’ ‘false breakout‘ trading style.

It’s the idea that when a stock or index goes through a key level, rather than continuing the trend, the trend usually reverses. That’s what happened at the bottom of the range in early April, and the top of the range in late April.

And if our prediction is right, you’ll see the market test the high and low of this range for the rest of the year. It’s something of a holding pattern if you like.

Keeping the stock market in that range is likely to be the Reserve Bank of Australia (RBA) and its interest rate policy.

The reason for that is simple. Dividend stocks are now trading as high as they’re likely to go unless the RBA cuts interest rates. This is what we mean when we say the market will trade on a ‘relative yield basis’ for the rest of the year (something we wrote about a couple of months ago).

With the RBA cash rate at 3% and online bank deposit rates around 4-5%, it’s hard to see dividend yields falling much lower than the current level.

That’s why we believe the market is unlikely to rise much higher than today’s level. There is however, one thing that could scupper our argument – rising company profits.

What Happens to Stocks if the RBA Cuts?

The bigger than expected profit results from Australian & New Zealand Banking Group [ASX: ANZ] and Westpac Banking Corporation [ASX: WBC], plus increased dividend payouts helped push the Aussie market higher last week.

It pushed the index past the previous high and created what Murray calls a ‘false break’. We pointed that out to you last week, predicting that stocks would soon fall back to the low end of the range.

That hasn’t happened yet. But it should happen, unless investors keep buying dividend stocks at this level. In order for them to do so, they’ll need to believe that companies can increase earnings (and therefore increase dividends)…or that the Reserve Bank of Australia will cut interest rates.

Seeing as the next RBA decision is today, perhaps that’s what investors are holding out for. They don’t want to sell stocks on the chance the RBA cuts rates, which could send stocks higher…but you can be almost certain that if the RBA doesn’t cut rates then stocks will tumble this afternoon.

Now, that’s all guesswork. Anything could happen. If the markets were 100% predictable you’d never make money from them. It’s the unpredictability and the potential to get things wrong that allows you to potentially make a lot of money when you get things right.

Australian Stocks on the Road to 7,000

And for now we’ll assume we’re right. That’s why we don’t want you to sell stocks at this point. This is the time to hold. If, as we expect, stocks fall to the low end of the range, that will be your chance to buy more dividend paying stocks at a discount.

If stocks defy our expectations and climb higher, you’ll still be ahead of the game because you chose to keep hold of your stocks. If a new ‘holding pattern’ forms we’ll have to revisit our opinion on whether you should buy stocks around this level.

Of course, the biggest threat to our prediction is that stocks could fall to the bottom of the range and then keep falling. We don’t believe that will happen in the short term, but it’s a possibility.

Even though we’re banking on Australian stocks hitting 7,000 points within two years, we’re still keeping a fairly conservative approach to stocks. Depending on your attitude to risk, you probably shouldn’t have more than 50% of your investments tied up in stocks. So if the Australian market doesn’t hit 7,000 points as we expect, at least you won’t have put your entire savings on the line.

That said, if you asked us to bet whether the market will be higher or lower two years from now, we wouldn’t hesitate to say higher…much higher.

Cheers,
Kris

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P.S. With interest rates at record lows and dividend yields falling, it pays to think of simple and practical ways to benefit from low rates. In today’s
Money Morning Premium I reveal one way to get at least some financial security during this volatile time. Click here to upgrade now.

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.


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