Secrets Of Success: Prepare for volatile market in 2006
Saturday 03 December 2005
Wise heads are starting to worry about the outlook for the stock market in 2006 and, having been positive for the last three years, when many market-watchers were not, it seems that this time the note of caution might be justified. There are a number of plausible reasons why some sort of correction might be in order next year, because, for one, it is not in the nature of stock markets to go up or down in continuous straight lines.
In fact, as Professor Robert Shiller and others have pointed out, historical experience indicates that the markets are far more volatile than the underlying trends in profits and economic activity, on which they ultimately depend, can possibly justify.
At the moment, the most striking feature of the global financial system is how little volatility there is by historical standards. Step back far enough and in hindsight the charts make it look as if the stock markets have gone up in a pretty continuous straight line since the lows of the bear market were touched in March 2003 (six months earlier in the US). Coupled with low interest rates, the absence of volatility has encouraged (or perhaps forced) investors to embrace risky assets with more than customary abandon.
It is a simple visual observation that the longer back in time you look, the less significant even big, scary events, such as the October 1987 market crash, appear. Months such as October, which saw some hefty corrections, are a useful reminder that this is not a blanket state of affairs. But the fact remains that on a global scale, investors are willingly taking on more risk today across a range of asset classes than traditionally they have been happy with.
In his latest quarterly letter to clients, for example, Jeremy Grantham, the founder of the US quantitative-based fund management firm Grantham Mayo Van Otterloo, which has data on every conceivable market trend you can imagine, says bluntly that many risk measures have reached all-time record lows. He thinks that this has resulted in "probably the lowest-risk premium on average recorded in modern times".
The kind of measures he is talking about are the spread between the yields on emerging market debt and US Treasury bonds (now very low), the similar story with junk bonds and AAA corporate debt (also very low) and the near-unprecedented discount at which "quality stocks" are valued by investors. Quality in this regard is a reference to companies with strong balance sheets, high returns on capital and stable profitability, for which you would normally expect to pay a premium.
Grantham also quotes the soon-to-depart chairman of the Federal Reserve, Alan Greenspan, who issued this apt warning during the summer: "History cautions that extended periods of low concern about credit risk have been invariably followed by reversal, with an attendant fall in the prices of risky assets."
Greenspan, in Grant-ham's opinion, and that of many others, deserves the "chutzpah of the year" award for this remark, given the central role the Fed's low-interest rate policy has played in encouraging the flight to risky assets.
One reason for the current state of affairs, Grantham also suggests, is a behavioural one. At any point in time, investors as a group are prone to extrapolate forward the continuation of current market conditions, even to the point of recklessness, as may be happening now.
Also a cause for concern, in his view, is the potentially destabilising activity of the hedge fund industry, which has $1 trillion of funds under management, which it leverages several times over in the pursuit of short-term returns.
If the markets do turn down, as they will do at some point, quite probably in 2006, this could create a worrying downward spiral. (The alternative perspective on the hedge fund point is that, because hedge funds as a class are prepared to accept risks that the majority of investors do not understand, their primary impact is to reduce, not increase, the level of overall risk in the financial system by adding new sources of diversification - an idea that has yet to be fully tested.)
Other analysts also see the scope for a downturn in the technical behaviour of the markets. Robin Griffiths, the head of asset allocation at Rathbones, says that 2006 looks like being "a tougher year", with a probable correction in most equity markets, matched by higher bond yields.
David Fuller, another seasoned market observer, who has called the current three-year recovery in equity markets, including the strength of resources, mining and emerging markets with impressive accuracy, also now detects some familiar trend-ending signs in a number of markets following their strong recent performance. He thinks 2006 will see a significant correction, probably led by Wall Street.
Of course, any sign that this kind of view is developing into a broad market consensus may well suggest that next year might, once again, surprise us on the upside. The year-end calculations of mainstream forecasters will give us some clue as to whether we need to lay off in a contrarian direction. But what cannot be denied is that the risk premium investors are currently prepared to accept for riskier assets is very low by historical standards. It means that markets are now somewhat "priced for perfection" and the greater short-term risk is clearly disappointment rather than further gains.
Timing the turning points in markets can never be a precise art, and attempting to outguess the rest of the investment community is a risky and potentially costly business. But investors, I would suggest, should be on the lookout for a significant correction, and prepare accordingly. The important thing is not to be caught out, or panicked, by the next cyclical downward move. The good news is it will create opportunities to buy into the major trends of the moment, such as commodities/resources and selected emerging markets, as the long-term outlook on those fronts continues to look promising.
Buyers beware of new-build home headaches
Are you ready for pensions reforms?
Dirty tricks in a divorce can cause some nasty surprises
Simon Read: Frozen in time - the expat British pensioners who deserve a better deal
Number of serially under-performing investment funds has increased by a fifth, survey reveals
- 1 Benedict Cumberbatch says Hollywood is better for black British actors: 'I think as far as coloured actors go it gets really difficult in the UK'
- 2 Man who held up 'hire me' sign at Waterloo station returns a year later with 'I'm hiring' sign
- 3 UK weather: Snow to fall in the coming week with sub-zero temperatures to last until early February
- 4 Saudi preacher who 'raped and tortured' his five -year-old daughter to death is released after paying 'blood money'
- 5 Warriors in ancient Iraq suffered Post-Traumatic Stress Disorder more than 3,000 years ago, say researchers
Nigel Farage: NHS might have to be replaced by private health insurance
'We would evict Queen from Buckingham Palace and allocate her council house,' say Greens
French court convicts three over homophobic tweets, in case hailed as a 'significant victory' by LGBT rights campaigners
British Muslim school children suffering a backlash of abuse following Paris attacks
George Galloway condemns 'racist, Islamophobic, hypocritical rag' Charlie Hebdo at freedom of speech rally
Islamic history is full of free thinkers - but recent attempts to suppress critical thought are verging on the absurd
iJobs Money & Business
£18000 - £20000 per annum: Recruitment Genius: This rapidly expanding business...
Negotiable: Recruitment Genius: A Tax Assistant is required to join a leading ...
£16000 - £25000 per annum: Recruitment Genius: This is an exciting opportunity...
£45000 - £47000 per annum + bonus + benefits: Ashdown Group: Java Developer / ...
Day In a Page
Hibernate during winter and make your living during the summer at this busy guesthouse with panoramic sea views, in the village of Lynton
A four-bedroom penthouse next to the Tate with direct views of St Paul's from two floors of luxurious living space
A four-bedroom detached home surrounded by spacious gardens and woodland, close to New Pudsey
An 18th-century, three-bedroom home near Langstone Harbour built from ships beams with vaulted ceilings and wood burning stoves
A five-bedroom semi-detached home with a mix of period and modern features in a popular and convenient location
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
A three-bedroom villa with self-contained flat, minutes from Lake Windermere
A deceptively spacious, beautifully presented Georgian home with 3000sq ft of living space and five reception rooms
A five-bedroom Victorian home with four receptions, superb gardens and paddock in Pembury
An eight-bedroom house on the south side of the The Green with cinema, wine cellars and summer house
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park
A state-of-the-art farm-building conversion on the former Cliveden Estate, with 11,420sq ft of internal space, cinema and wine cellar
A three-bedroom, 15th-century cottage with original features in the picturesque village of Sissinghurst
A six-bedroom terraced house with large south-facing roof terrace, cinema room and wine cellar
A new seven-bedroom home built in Queen Anne-style with swimming pool and parkland views in Mortimer
A listed, four-bedroom farmhouse in the rural hamlet of Rushall with detached barn, four acres of gardens and paddocks
A first-floor flat with two bedrooms, a spacious reception room and communal grounds in a leafy part of London
A three-bedroom flat with a spacious rootop terrace and balcony, accessed from a private gated courtyard
A Grade II-listed pile with six bedrooms, stables and 39 acres of grounds in Standlake
A two-bedroom flat with boutique hotel-style interiors, close to the foodie haunt of West End Lane
A two-bedroom flat in a beautiful old vicarage, with many original features, close to the city centre
A three-bedroom 16th-century home with an aga kitchen, private gardens and heated outdoor pool, in Hadleigh
A three-bedrom home in sought-after Queen's Gate Mews, with Italian marble-finished bathrooms
Surrounded by glorious countryside in the village of Udimore, sits this impressive four-kiln oast and barn conversion
A five-bedroom house in the picturesque village of Kettlewell, north Yorkshire
An 18th-century former coaching inn with original staircase, open fireplaces and beams throughout
A Grade II-listed Georgian town house with three bedrooms and a south-facing courtyard, near Arundel Castle
Feel on top of the world at this über chic penthouse on the 37th floor of one of Europe’s tallest blocks.
A Grade II-listed Victorian villa with six bedrooms and two further cottages, all with spectacular sea views
A grade II-listed, Georgian cottage with mature 50ft garden, perfect for summer entertaining
A magnificent Georgian pile with turrets, seven bedrooms, a heated pool and four acres of gardens
Fairoak Farm has five bedroom suites, gym, outdoor swimming pool and golf course
Chic two-bedroom river-fronted flat with a private lift that delivers you directly to your home
A spectacular seven-bedroom Tudor pile, once owned by Henry VIII, with 18 acres of land
A seven-bedroom Georgian property previously used as a picturesque wedding venue
A split-level flat in a church conversion with two en suite bedrooms and 1,200sq ft of living space
A three-bedroom bungalow situated behind an impressive stone wall, £645,000
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads
Chapel House is a former vicarage with nine bedrooms in the beautiful Upper Wye Valley
A five-bedroom B&B and separate owner's accomodation with potential for conversion
Enjoy summer by the Thames in this two double-bedroom converted warehouse in Rotherhithe village