Page 1 of 8

The views expressed in this report are those of Lesley Beath and may differ from Morningstar's views.

Reviewed this week

Overview
What next? More...

• BHP Billiton (BHP)
  The stock is in limbo. More...
• Rio Tinto (RIO)
  The long-term chart is of concern. More...
• Fortescue Metals (FMG)
  On the brink. More...
• Commonwealth Bank (CBA)
  Waiting for a break of resistance. More...
• National Australia Bank (NAB)
  Risk in the short term, long-term indicators remain favourable. More...
• ANZ Bank (ANZ)
  A Sell signal on the stochastic. More...

Please note: before making an investment decision, Morningstar recommends you read the fundamental research available on these stocks.

Disclaimer: To the extent that any content in this report constitutes advice, it is general advice that has been prepared by Lesley Beath without taking into account the particular investment objectives, financial situation and particular needs of any individual investors. If necessary, you should consult with a licensed investment adviser or dealer in securities such as a stockbroker before making an investment decision. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

Overview

Last week's fall in the US equity market did not really come as a surprise as the major indices had risen to an overextended level, and the VIX had been hovering around significant support for the past couple of months. Many of the smaller world equity markets had been correcting since late last year, giving some warning that upside potential was waning.

In Australia, the Resources and the Banks had failed to move in synch, with strength in one offsetting gains in the other, to keep a lid on the broader market. The All Ords pushed into an area of strong resistance in early February but was unable to break topside. Last week's fall has taken the index to test the July uptrend and indications are that a short-term bounce is possible.

But the real question is how long that bounce will last, and whether or not this is the beginning of an overdue correction in the US which will have a negative impact on the domestic market.

At this stage, it appears as though the bounce will be short-lived and that a correction of medium-term significance is unfolding.

Let's concentrate on the US for a minute, and compare the recent action to what was happening last April. At that time, the VIX tested support early in the month and traded around that support level until it spiked higher a few weeks later. That spike was followed by a short reprieve, which was accompanied by a bounce in the S&P 500. But after a couple of days, the equity markets were hit again as fears of contagion from the Greek crisis unfolded, and as China tightened.

The VIX then pushed from a low of 15.5 to a high of 48.2 by May 21, and US equities suffered their first major correction since March 2009.

Will this time be different?

That is the question which I raised at the beginning of February when the VIX was bouncing from support. I don't know for certain, nobody ever really does, but I do know that markets need to correct at certain times, and when they get as overextended as the US has become, it is only a matter of time before they consolidate or correct. Failure to do so leads to an extremely high risk situation, where downside potential increases dramatically.

What the global market has in its favour at the moment is that many of its components have already been correcting for several months. Thus some of the downside risk has already been eradicated. But in the US, the S&P 500 pushed to new recovery highs in mid February, taking the rally from the July low to 33%. The Nasdaq 100 increased by 41% over the same period. This has created an overbought situation, at risk of a medium-term correction. And it is unlikely that a correction here will be ignored.

So what's the risk in Australia?

Well, as noted above, the All Ords is testing short-term support and a bounce is likely. But with the Resource side of the market still a concern, a break above the recent high is a low probability. A pullback toward the 200DMA appears likely; this creates risk to approximately 4650. And on the ASX 200 to roughly 4600.

(click image to enlarge)

Just as upside potential over the past few months was dependent upon the Financials and Resources moving in tandem, downside risk in the near term will rely on how these sectors perform.