Hamish McRae: Why shares thrive while the economy flounders - Hamish McRae - Business Comment - The Independent

Hamish McRae: Why shares thrive while the economy flounders

Economic View: Apply the buy/sell rule to equities over the past 40 years and you would have spent 2000 to 2008 outside the market

If the economy is so weak, why are share prices so strong? The short answer is that the money the central banks are spraying around has to go somewhere, but that is neither a complete nor a satisfactory one. It must be true that liquidity is driving everything at the moment, but there have been sharp reactions in some markets, notably commodities, energy and gold. And the tidal wave of money has yet to float off some countries' property markets, including bits of our own one.

There has been no shortage of bad news around, including some weak data from the US and Germany, yet both equities and bonds have sustained their solid performance this year. For equities, the S&P 500 index is up 11.4 per cent this year and 17.7 per cent on 12 months earlier; the FT 100 is up 10.7 per cent and 17.8 per cent; the German DAX is only up 1.7 per cent this year but 17.4 per cent on a year earlier; and the French CAC 5.5 ahead this year and, perhaps surprisingly, 26.2 per cent over the past year. France's President Hollande may say he hates the rich but under his stewardship they have got a lot richer.

Prime-bond yields have remained remarkably low, though for the US and UK they are not back down to the levels of last summer when the flight to safe havens was at its height. Thus 10-year government bond yields are now 1.7 per cent for the US and UK, 1.25 per cent for Germany, and 1.75 per cent for France. That is its lowest ever. Indeed, this revival of confidence in France's ability to handle its debt is remarkable, for a year ago France was paying 3 per cent for 10-year debt. So much for the loss of the AAA status; the markets evidently don't give a toss what the rating agencies think.

So what happens next? Three or four months ago the talk was all of the "great rotation". Bond yields would rise as people switched to equities. It hasn't happened. Equities have done well, but so too have bonds. So the first issue is how solid are both of these rises.

Equities first: I have been looking at a couple of rather different commentaries on global equities, one from a giant, Goldman Sachs, the other from a boutique, Longview Economics. The Goldman view is that you should be overweight equities and underweight bonds. In other words, the rotation will indeed occur. The case for equities is that while the past month or so has seen some negative reaction, some of the risks are now accepted and these will therefore tend to diminish in the months ahead. Goldman thinks that one should remain overweight in equities for the next year. Valuations in the US are a bit higher than they have been in the long term, but rather lower outside the US.

By contrast it thinks bonds are overvalued. You can see in the top graph what has happened to UK 10-year gilts, together with a calculation of what a fair value should be, with one standard deviation on either side of that band. Looking forward, Goldman projects that yields will rise to around 3.5 per cent by 2017.

Longview Economics focuses on equities and asks: how long will the Western secular bull market last? Its answer, to give away the punchline, is about two years. It makes its own calculation on what is fair value for shares and plots to what extent shares have been above or below fair value. You can see in the bottom graph the result, with bands shown at one standard deviation and two standard deviations above and below it. As you can see, this indicator has been signalling a "buy" since August last year and remains in buy territory.

Both studies are really just a form of discipline: an effort to set present market valuations into some kind of historical context. You can say that markets are never "wrong", in the sense that they simply reflect the balance of hopes and fears of investors at any one moment in time. But if you look at both those graphs you can see that prices do spend considerable periods of time deviating sharply from a norm, more so in the case of equities than bonds.

There is no magic about a standard deviation: it is simply a measure of variance of any set of data, with one standard deviation being the square root of its variance. If the data has a typical form, say the classic bell-curve, you would expect numbers to be within one standard deviation either side of the mean for a little more than two-thirds of the time. So when prices are outside those bands you could say that you have a buy or a sell signal.

Of course, markets may spend a long time deviating from the centre point of their distribution. Apply the buy/sell rule to equities over the past 40 years and you would have spent the period from 2000 to 2008 outside the market. While that with hindsight would not have been a bad idea, you would probably have re-entered the market too early. But when someone said to me in March 2009 that they thought this was a once-in-a-generation opportunity to get into shares, you can see from the chart that this turned out to be a pretty accurate judgement.

None of this is more than the most general of guides for investment strategy. It does not at all explain what has been happening in bond markets, which do look a bit of an aberration. Anyone investing in equities can take some comfort from the data, but it is perfectly possible to construct other valuation models that give a more negative signal.

My point is the simple one that it is possible to explain why shares are doing pretty well, notwithstanding the sombre flow of economic information. The really big questions are what will happen when the central banks stop printing the money. When will they start to pull back? What will they do with the stock of public debt they hold? What are the inflationary consequences? And what are the specific implications for the eurozone? But the answers to those are many months away.

Life and Style
tech
Arts and Entertainment
Robin Thicke's video for 'Blurred Lines' has been criticised for condoning rape
music
News
Paper trail: the wedding photograph found in the rubble after 9/11 – it took Elizabeth Keefe 13 years to find the people in it
newsWho are the people in this photo? It took Elizabeth Stringer Keefe 13 years to find out
Voices
Yes supporters gather outside the Usher Hall, which is hosting a Night for Scotland in Edinburgh
voicesBen Judah: Is there a third option for England and Scotland that keeps everyone happy?
PROMOTED VIDEO
Arts and Entertainment
Matt Damon as Jason Bourne in The Bourne Ultimatum (2007)
filmMatt Damon in talks to return
News
peopleThe report and photo dedicated to the actress’s decolletage has, unsurprisingly, provoked anger
Arts and Entertainment
Evil eye: Douglas Adams in 'mad genius' pose
booksNew biography sheds light on comic genius of Douglas Adams
Life and Style
tech... and together they're worth at least £100 million
Arts and Entertainment
While many films were released, few managed to match the success of James Bond blockbuster 'Skyfall'
filmsDaniel Craig is believed to be donning skies as 007 for the first time
Arts and Entertainment
Fringe show: 'Cilla', with Sheridan Smith in the title role and Aneurin Barnard as her future husband Bobby Willis
tvEllen E Jones on ITV's 'Cilla'
News
ebooksAn unforgettable anthology of contemporary reportage
Life and Style
Bono and Apple CEO Tim Cook announced U2's surprise new album at the iPhone 6 launch
tech(but you can't escape: Bono is always on your iPhone)
Sport
Tim Wiese
sport
Life and Style
Kim Kardashian drawn backlash over her sexy swimsuit selfie, called 'disgusting' and 'nasty'
fashionCritics say magazine only pays attention to fashion trends among rich, white women
Arts and Entertainment
TVShows like Agents of S.H.I.E.L.D are little more than marketing tools
Arts and Entertainment
Hit the roof: hot-tub cinema east London
architectureFrom pools to football pitches, rooftop living is looking up
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Sales Executive

£20 - 24k (Uncapped Commission - £35k Year 1 OTE): Guru Careers: We are seekin...

Payroll & Accounts Assistant

£20 - 24k + Benefits: Guru Careers: This is a great opportunity for an enthusi...

SQL Developer - Watford/NW London - £280 - £320 p/d - 6 months

£280 - £320 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

Senior BA - Insurance **URGENT**

£400 - £450 Per Day: Clearwater People Solutions Ltd: **URGENT CONTRACT ROLE**...

Day In a Page

Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments
These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

Widespread fear of Isis is producing strange bedfellows

Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
Topshop goes part Athena poster, part last spring Prada

Topshop goes part Athena poster, part last spring Prada

Shoppers don't come to Topshop for the unique
How to make a Lego masterpiece

How to make a Lego masterpiece

Toy breaks out of the nursery and heads for the gallery
Meet the ‘Endies’ – city dwellers who are too poor to have fun

Meet the ‘Endies’ – city dwellers who are too poor to have fun

Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

Ian Paisley’s decision to make peace with his IRA enemies

His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam
'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

Exclusive extract from Janis Winehouse's poignant new memoir
Is this the role to win Cumberbatch an Oscar?

Is this the role to win Cumberbatch an Oscar?

The Imitation Game, film review
England and Roy Hodgson take a joint step towards redemption in Basel

England and Hodgson take a joint step towards redemption

Welbeck double puts England on the road to Euro 2016
Relatives fight over Vivian Maier’s rare photos

Relatives fight over Vivian Maier’s rare photos

Pictures removed from public view as courts decide ownership
‘Fashion has to be fun. It’s a big business, not a cure for cancer’

‘Fashion has to be fun. It’s a big business, not a cure for cancer’

Donatella Versace at New York Fashion Week