Beware the New Year blues

JONATHAN DAVIS
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The Independent Online

How are the markets going to pan out over the next few months? The precise and correct answer, as always, is "we don't know". The economic world is a complex system and the most secure finding in the social sciences is that forecasting the inherently unpredictable is a painful and frequently chastening experience.

How are the markets going to pan out over the next few months? The precise and correct answer, as always, is "we don't know". The economic world is a complex system and the most secure finding in the social sciences is that forecasting the inherently unpredictable is a painful and frequently chastening experience.

Having been engaged to speak at ProShare's investment club seminar last weekend, I took the opportunity to dig out some pertinent quotations and statistics. One I came up with an old favourite of mine, from the economist JK Galbraith who observed pithily that "economists forecast not because they know, but because they are asked", a statement that is well worth keeping in mind at all times, and especially around New Year when the forecasting season reaches its annual zenith.

Another quotation I like, but one that I didn't use, was given to me by Peter Bernstein, the American author and market strategist. He tells how during the war the Nobel laureate economist Kenneth Arrow recounted a conversation with an American general who insisted on receiving detailed forecasts from his planners, despite the overwhelming evidence that they were of no practical value. "The general," so it was reported back to Arrow, "knows that the forecasts are of no value. But he still needs them for planning purposes."

Investors are in a similar boat, as we all need some kind of forecasting framework, whatever its validity, if only to help us keep our emotions – dangerous commodities in investment – in check. Clearly, such exercises need to be treated with great caution. Peter Bernstein also highlighted recently a study by two American academics who in 1975 produced a 25-year forecast for shares, bonds and cash for the period 1975-2000. It was based on what at the time was a pioneering study of the long-term returns on different asset classes in the preceding 175 years.

Now that we have reached the end of the century, we can look back on this exercise and see quite how wrong two blue-chip academic forecasters can be. Instead of the 7 per cent annual return predicted for shares, the markets have delivered almost twice that level of return since. The forecasts for bonds and inflation were equally wide of the mark.

Undaunted, however, I am for once prepared to make some kind of forecast for how the next few months might now play out. It is clear that the economic and corporate news is going to continue to deteriorate over the next few weeks. Anyone looking for signs of hopes from reading the press and other media is certain to be disappointed. The next few months are going to see a fairly relentless diet of hefty losses, rising unemployment and gloomy news from the consumer front.

Far be it from me to take issue with such an illustrious figure as the Bank of England's Deputy Governor Mervyn King, but his reported view that the UK may well avoid a recession altogether is a brave one. My guess is that when the statisticians finally come to write the after-the-event history of events this year, it may well turn out that a recession started earlier than we currently are led to believe, and certainly predated the events of 11 September.

Experience suggests that the authorities are the last people to admit that a recession is either coming or already under way. No doubt they feel it is not their job to "talk down the economy". The scale and frequency of the interest-rate cuts we have seen on both sides of the Atlantic this year paint a rather different picture of the likely path that the economy, both in the United States and over here, may yet take. It is instructive to recall that it is only a few months ago that the Bank's monetary policy committee was still debating whether the next move on interest rates should be up or down.

Having said that, the honest answer is that we do not know how deep and how prolonged the recession will be, but there is as yet no reason to believe that it will be unduly severe by the standards of history. If that view is right, where does that leave the stock market? As is well known, the market's job is to look forward and discount the future.

It typically turns up several months before the economy itself hits bottom and starts to turn. While this always happens in the end, it does not mean that the markets are infallible: quite often they discount a recovery that does not in fact happen.

The question now is whether the stock market has looked across the valley of the coming recession (and the war against terror) and seen a strong recovery, or whether it has merely anticipated some less meaningful bounce back, which might bring us the so-called W-shaped recovery (down, up, down, up, in plain language).

According to Ken Fisher, the American private client money manager whose views I have reported before, and whose track record on these things is very good, there are several good reasons for thinking that we may yet have another bad dose of nerves and gloom before this particular bear market has finally run its course. In his view this will probably take place some time around the New Year, at which point we will still be reading some seriously gloomy reports about the future of the market in general, and equities in particular.

He also suspects that most professional institutional forecasters will be reluctant to call another big rise in the market next year, having called such a rise in both of the last two years and being proved spectacularly wrong on both occasions. This time they will go for something more modest and will, of course, again be confounded by events: this time, however, with the targets being missed on the upside rather than downside.

If he is right, then the year 2002, once it gets going, could well be a pretty good one for the stock market. That in itself says nothing about the sustainable level of the market – which is clearly still very highly valued – but it does give the lie to the idea that even a market that is moving sideways cannot deliver strong trading opportunities for those with the courage to take them.

At this stage, investors should still be relatively conservative in their asset allocations, but even if the current rally expires into a new round of doom and gloom, they should be getting ready to increase their equity exposure in readiness for the next bull phase, when it comes. But don't expect the headlines to be favourable at that point. It's simply not the way the markets work. There's nothing to say that I won't be totally wrong about this as well, but it seems a reasonable working hypothesis.

Davisbiz@aol.com

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