Australia Stocks at 21-Month High, but Brace for Correction

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Investors have been reaping the benefits of a bull run on the Australian Securities Exchange, but a correction is looming and they should take heed, said analysts.

The index crossed the psychological 4,900 mark on Wednesday, highs not seen in 21 months, riding off the back of this year's broad-based rally in global markets.

But David Lennox, resource analyst at Sydney-based stock market research house Fat Prophets, warned investors to take a cautious approach. In his view the ASX 200 is set to correct by up to 5 percent over the next three months.

"We have had a good run on the back of improved sentiment in the overall global economy, especially within China and the U.S., where the market has gained confidence. But the rally is not endless, we have had a decent run and sooner or later the markets will realize that all the things we thought were rectified - are not," said Lennox.

Latest Chinese government figures showed growth picked up to 7.9 percent in the final three months of 2012, from 7.4 percent in the previous quarter. However, concerns over a bubble in the region's property market persist.

(Read More: Property Risk Reigniting as China Economy Turns Corner)

The U.S. economy has also rebounded in the fourth quarter to 3 percent, an improvement on 1.8 percent in the previous quarter, but investors are wary of how its government will tackle cutting its huge deficit and simultaneously stimulating growth.

Any changes to the outlook for China or the U.S., according to Fat Prophets' Lennox, could quickly turn sentiment around. The situation in the U.S. is a crucial risk, where a lack of resolution on budget cuts could push the world's largest economy into a recession.

"The U.S. will have to reign in government sector spending or it would go into deeper debt. We will be watching closely which programs are to be cut and what impact on private sector. These are the two key factors," said Lennox.

Mak Remissa | AFP | Getty Images

Australian Prime Minister Julia Gillard

Roger Montgomery, portfolio manager at Montgomery Investment Management, added low interest rates, led by the U.S., have driven the strength in the Australian equities market. If the period of low rates combined with excess liquidity comes to an end, the rally could be put in jeopardy.

"There are three factors driving the rally, all stemming back to low interest rates. Investors are now moving from cash to stocks following the Australian Reserve Bank's interest rate cuts. Companies are benefiting because they are able to borrow cheaply and improve their return on equity, and finally lower rates translate to higher intrinsic value for businesses," he said.

The Reserve Bank of Australia cut interest rates by 25 basis points to 3 percent in December last year, levels not seen since the financial crisis, the seventh rate cut during 2012.

(Read More: Australia Central Bank Cuts Rates to Record Low)

Montgomery added: "We have recently seen the Fed hint that the period of maximum liquidity is due to come to an end. A return to normalized interest rates and inflation levels will reverse the positive impacts of low interest rates on markets."

Earlier this month, the U.S. Federal Open Market Committee's monetary policy review demonstrated some members were keen to halt printing money as early as this year.

(Read More: Some Members See QE End before End of 2013: Fed)

Prasad Patkar, of Sydney-based Platypus Asset Management, said a 5 percent correction is possible for Aussie stocks if latest company earnings out in February disappoint. However, long-term he sees further upside in the rally and forecasts the ASX 200 will hit 5,000 in the coming months.

"The rally has been driven by PE (price to earnings) expansion...therefore, further upside in the short term is contingent on corporate results delivered in the second week of February 2013. If companies beat expectations and deliver a positive outlook commentary, the rally can certainly keep going in the short-term. Otherwise there could be a small pull back and we will consolidate the gains made so far," he said.

Political Risk?

Furthermore, on Wednesday Australian Prime Minister Julia Gillard made a surprise announcement to hold elections on September 14. Traditionally Australian governments give their opposition little more than a month's notice to maintain a strategic advantage, according to media reports.

(Read More: Australian PM Surprises With September Election Call)

Gillard's motivations could stem from her Labor Party's desire to buy some time to regain popularity with the electorate, given her current undesirable poll position, although the opposition will enjoy the same benefit.

According to Lennox, a victory for the opposing Liberal Party, led by Tony Abbott, would be beneficial for some sectors, namely coal and iron ore mining firms. These sectors would benefit from Abbott's promise of lifting heavy taxes on the mining sector, including the controversial carbon tax.

Montgomery advised investors to avoid the mining sector, specifically iron ore, within Australia, and instead concentrate on retail (including banks), healthcare and companies driven by the growth of the internet.