Investors get wily in a placid market

Jonathan Davis: Exiting with more of a whimper than a bang
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The Independent Online

Could it be that the bull market is going to end not with a bang but in a whimper? It is easy to start thinking that, given the placid nature of today's markets. The tech stock crash apart, the overriding feature of markets this year has been the absence of any real dramatic moves in the main indices, though individual stock volatility remains relatively high. The US and UK markets have been caught in relatively narrow trading ranges for some weeks.

Could it be that the bull market is going to end not with a bang but in a whimper? It is easy to start thinking that, given the placid nature of today's markets. The tech stock crash apart, the overriding feature of markets this year has been the absence of any real dramatic moves in the main indices, though individual stock volatility remains relatively high. The US and UK markets have been caught in relatively narrow trading ranges for some weeks.

The Federal Reserve's move to raise interest rates in an effort to slow the American economy has so far passed off without serious negative effect on sentiment. As has often been mentioned, the final year of a US Presidential term is rarely bad for the stock market (though not as good overall as the third year of the presidential cycle). In the absence of any sudden or dramatic shocks, it is not impossible that this year could simply go on being just plain dull.

And maybe it could go on looking like that for even longer. A couple of years ago, Bill Gross, one of the best-known US bond fund managers, advanced the hypothesis that we were entering a period of relative calm in markets that he dubbed "a return to Butler Creek" (named after a sleepy, slow-running stream in his childhood neighbourhood).

He meant that instead of high drama big swing markets, characterised by double-digit returns, we could be facing a period of stability marked by enduring low inflation, low interest rates and steady but unspectacular growth. This, he suggested could be the prelude of a period of years in which returns from the markets were of the order of 6 per cent per annum year after year.

For those who like to draw comparisons between the current and past periods of history, the analogy would be with the 1950s rather than the 1960s - a period of prosperity, but not one characterised by the same kind of stock market exuberance that we have witnessed in the past decade. In such conditions, public interest in the stock markets would gradually decline to more traditional levels and brokers and fund managers would be forced to compete harder to win business.

Is that a plausible picture? In many ways, the answer has to be yes. While there is clearly some scope for interest rates to fall below their previous lows once the present round of rate increases has run its course, what we do know is that the long secular downward trend in interest rates which has been one of the great motors of the bull market is almost certainly coming to an end.

That puts an upper bound on the kind of market rises that can be realistically expected. But there is no such narrow limit on the downside. The next recession, or any unforeseen external shock, will surely still find the markets vulnerable to a painful correction.

In markets which are capitalising so much future expected growth, the inevitable consequence is that sentiment will be the dominant factor in determining the extent of any downwards move. Even a mild deterioration in the fundamentals could lead to exaggerated consequences if investors lose their confidence.

That is one reason why Alan Greenspan and other central bankers now devote so much time to trying to manage investor expectations. They are trying to retain confidence in the markets while lowering expectations of future returns, a tricky balancing act.

But until or unless investors can come to terms with the fact that returns of 20 per cent a year compound are not going to continue indefinitely, the risks to the Butler Creek hypothesis - a period of slow but steady advance in the stock market - will remain. So far, the markets have proved remarkably resilient. Some of the froth typified by the tech stock bubble has begun to dissipate, with limited wider consequences.

Even though spreads over government bonds are wider than they were, the dramatic increase in scale and activity of corporate bond markets all round the world is evidence that investors are still sufficiently confident about the future to lend long term money at fixed rates on a scale that has not been seen for a long time.

If we are entering an extended period of dull and placid markets, it only makes it more important to manage the costs of investment carefully. The latest figures on fund performance underline that point once more. If you take the All Companies sector in the UK, the average actively managed fund is up about 12.3 per cent in the 17 months since April 1999 - a figure that is consistent with the Butler Creek hypothesis. But that is before taking bid/offer spread and other initial charges into account. Adjust for them, and the return drops to just 6.5 per cent.

In the Europe sector, which is where the best returns have been had over the past 17 months, the average fund is up by 40 per cent before all expenses and 33 per cent after taking them into account.

The message from these figures could not be plainer. In dull markets, when returns are less than 10 per cent a year, you cannot afford to give away too much of your return in unnecessary costs.

What is also the case is that there are gains to be had by diversifying across regions. At the moment the UK still looks relatively unattractive compared to other markets, especially those in Europe and Japan. In the very long term, the returns from these different markets should all broadly equalise, but it is becoming increasingly risky to leave yourself overexposed to your domestic market alone.

* bavisbiz@aol.com

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