Making sense of the market's new normal
In some ways, thanks to the credit crunch, this market is unlike any other. But long-term indicators can still be illuminating
Wednesday 06 March 2013
These are odd times for the markets. Even those of us who have argued that equities are likely to perform well, given that the rotation from bonds to equities will be a dominant theme for the next few years, will be impressed by the way in which share prices worldwide have managed to push on upwards.
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It is mainly symbolic that the Dow Jones industrial average should reach its all-time high this week, for the Dow includes only 30 shares and is unrepresentative of the market as a whole, but symbols affect confidence, and this new peak is both a reflection of that confidence and a driver of it.Notwithstanding the fears about the US "fiscal cliff", the slump in the eurozone economies, the Italian elections, and all the other stuff around, there seems to be a sense that the worst is really over. Growth will probably be sustained worldwide – and if it isn't the central banks will carry on printing the money.
At least, that is the mood of the moment. It could change. At the moment there is a positive feedback loop, in that higher share prices reduce the deficits of company pension funds, make it easier to raise new capital and thereby stimulate investment, and, at the margin, boost consumer confidence and hence final demand.
But anyone who notes that previous highs for the FTSE 100 index were reached on 31 December 1999 and 15 June 2007 will be aware that market enthusiasm is no assurance of further economic growth. On those two occasions it was quite the reverse. Early in the growth phase of an economic cycle a strong equity performance does indeed create positive feedback. Late in the cycle it is a signal that the end of the boom is in sight. Where are we now?
Common sense says that the present growth phase is, to put it mildly, immature. Some would say it is non-existent, but that rather overemphasises the position of Europe, for most of the rest of the world is growing decently. But however you look at it, the fact remains that there is plenty of spare capacity in most major economies, and in some of them a huge amount of spare capacity. So growth ought to be able to continue, and the mainstream expectation of a gradually strengthening expansion makes broad sense.
That does not, of course, necessarily mean that share prices will strengthen too, and to catch some sort of feeling for the mood of the equities markets worldwide I have been looking at some long-term indicators.
The first of these is not so much an indicator as a guide to strategy. It comes from Simon Ward at Henderson, who has devised a very simple investment rule-of-thumb. You look at annual real money growth in the G7 economies and see if it is rising faster or slower than the growth of industrial production. If it is faster, that suggests there is excess money around and you buy equities. If it is slower, you switch to cash and wait. There is one little tweak to the strategy in that the early phase of excess liquidity is often associated with weak output – central banks are printing the extra money in response to that weakness – so you wait for six months after the initial switch to excess liquidity before getting back into the market.
You can see the long-term results of such a strategy in the first graph. There were long periods in the 1970s and 1980s when you would have stayed in cash, and another such period in the run-up to the crash of 2008. You might miss out on the tops of the booms, but you avoid the worst of the slumps. At any rate, world stocks have risen by about a third since the last "buy" signal in September 2011, and there is still a liquidity surplus now, which suggests that the market has further to go.
The other indicators have been developed by Chris Watling at Longview Economics. There are number of these, and it would be nice to say that they all point to further rises in the markets. Unfortunately they don't; or rather, they are mixed.
Taking US data, some, such as the equity momentum indicator shown in the middle graph, are close to buy levels. But there is a sell signal from the optimism of professional share advisers: when they are optimistic, as they are now and have been for several months, you should do the opposite and sell. I rather like the idea that the professionals are usually wrong, even if recently they seem to have got it right.
At any rate, Chris Watling's view is that positive news from the US and the prospect of a return to growth in Europe in the second half of this year should underpin equities for a couple of months more, a view supported by one of the oldest of market adages, the first part of which is that one should "sell in May and go away".
The right-hand graph shows the average monthly return on of the S&P 500 since 1985. As you can see, the March/April/May period tends to be a good one for shares, the summer is uneven, and then things pick up from October onwards. That would seem to validate the second part of the adage, "stay away till St Leger Day", the last flat race of the season this year being on 14 September. That particular rule did not work last year, but the notion that spring is generally positive for shares seems reasonable enough.
The commonsense reaction to all of this is that while no one can possibly know how markets will move, the present strength of equities is not ridiculous in the way that the strength of the bond market was last summer. You can make a decent economic argument in support of the recovery and you can make a decent case for the positive feedback loop. My own feeling is that we are in the early stages of a return to normality. It won't be the same normality as the long boom from the early 1990s through to 2008, but it will be a cyclical upswing – albeit a scruffy one. Against that background the markets sort of make sense.
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