Mood change carries a whiff of the bear

Jonathan Davis
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The Independent Online

ALL ROUND the world, financial markets seem to me to be approaching a potentially crucial point of inflexion - one of those occasions when we may be about to witness an important change in direction, as we did in 1987 and 1994. It is a trite thing to say, though by definition undeniable, that where markets go is driven by the balance between buyers and sellers. But another way to look at the same phenomenon is to say that there is a constant battle for supremacy between worriers and optimists.

ALL ROUND the world, financial markets seem to me to be approaching a potentially crucial point of inflexion - one of those occasions when we may be about to witness an important change in direction, as we did in 1987 and 1994. It is a trite thing to say, though by definition undeniable, that where markets go is driven by the balance between buyers and sellers. But another way to look at the same phenomenon is to say that there is a constant battle for supremacy between worriers and optimists.

I think it is undeniable that the worriers have been having their best few months for years. Since the US stock market peaked in July, there has been a notable deterioration in investor sentiment. You can measure this in several ways. There is, first of all, the scale and nature of the decline in stock markets themselves. It is worth noting that the fall in the US stock market over three months has been of the order of 12 per cent, a sufficiently large fall over a sustained period to meet the traditional definitions of a serious market correction. Most other stock markets have followed the US market down. While the US stock market is probably oversold on a short-term view, implying that a short-term bounceback may continue, the underlying condition of the market is not looking good. If you put hi-tech stocks on one side, the US market as a whole has in fact been trading sideways for months. Falling stocks have outnumbered rising stocks for some time. In other words, this is beginning to look both quantitatively and qualitatively different in kind from many of the previous "buy on the dips" declines we have seen in the past few years.

Next, it is worth taking a look at what has happened in the bond markets. Here we are seeing a worrying trend on both sides of the Atlantic. Bond yields have risen sharply this year, a phenomenon that is usually associated with trouble ahead, especially if price inflation remains, as far as one can tell, firmly under control. The last time UK and US bond yields rose as sharply as this was in 1987, ahead of the stock market crash in the autumn of that year. A simple parallel of this sort does not necessarily mean much in itself - it is all too easy in investment to read too much into what later proves to be a chance correlation - but my view is that the bond market is indeed telling us something about investors' attitudes. If you believe that inflation is still under control, then the rise in bond yields is clearly suggesting that investors are demanding a higher return from all types of financial asset as compensation for holding them in the first place. There is other evidence that this is indeed the case. If you look at credit spreads (the gap between yields on different risk types of security) you can see something similar happening. The gap between the yield on low-grade corporate bonds, for example, is still higher than it was at the height of the "flight to quality" which followed the great hedge fund and Russian crises of last year.

Another interesting indicator is the price of gold, which has jumped from its 20-year-low earlier this summer of $250 per ounce to more than $320 per ounce last week. Gold is a traditional safe haven in times of looming trouble, and although much of the dramatic switchback in prices is readily explicable by one-off events (central banks changing their policy of gold sales, the enforced unwinding of hedged positions held by gold producers and the widespread use of gold as collateral for borrowing by hedge funds and others), it does seem also to be carrying a more important underlying message as well.

That message seems to be that investors are at long last becoming more risk averse (or realistic, depending on your point of view). The long bull market in shares has been driven upwards on the back of several things: among them are an unprecedented period of economic expansion; a technological revolution in the delivery of information which is having huge (but still incalculable) effects on corporate behaviour and profitability; and a prevailing backcloth of low interest rates and global peace, the like of which has not been seen before this century. Not surprisingly, this "golden age" has had an appreciable impact on investors' confidence about the future.

As Alan Greenspan, the chairman of the Federal Reserve, pointed out in a speech 10 days ago, this has been reflected in a steady lowering of the rate at which investors have been willing to discount both the future cash flows and the risk of their investments, particularly in the stock market. If shares are priced to provide a dividend yield of 2 per cent, against a long-run historical average of more than double that amount, it means that investors are today prepared to put much greater faith in the future earnings capacity of their shares than they have ever done before, when prudent investors preferred to realise 4 to 5 per cent of their investments in hard cash each year. A similar attitude has resulted in consumers and companies taking on unprecedented levels of debt in the past few years.

What seems to be happening now is that investors of all kinds are having second thoughts about this unprecedented display of confidence in the future. Greenspan himself wondered how long this confidence might endure. In the words of Stephen Lewis, the veteran bond market watcher at Monument Derivatives, "the change in investors' mood has been perceptible". It is too easy to say that this is all down to concerns about the next movement in interest rates (almost certainly higher in both the UK and US), the impact of the millennium bug (surely now all long since discounted) or other short-term events. The worry is that there is something more deep-seated at work.

There is nothing in the history of financial markets to say that this mood will not pass. Optimists will point to the fact that we are in a pre-presidential election year, which is traditionally good for stock markets. A number of Wall Street pundits, including Abby Cohen of Goldman Sachs, the current chart topper in the pundit stakes, are still bullish. She thinks the Dow Jones index (10,470 as I write) will hit 11,500 by the end of the year. It may be also that the switchback in the bond market, which has taken bond yields in both the UK and US to 6.3 per cent this year, is also simply overdone.

But I am not so sure. This market simply doesn't feel very good. It could just be, as Stephen Lewis for one suspects, that what we are seeing is simply the start of an old-fashioned bear market. A bear market, he points out, is quite distinct from a stock market crash, which can usually be attributed to some underlying monetary or real world cause. Bear markets by contrast are simply reflections of changes in investor sentiment. Nobody knows for certain which way the markets will jump. The next few weeks are likely to give us a better indication of whether the current jitters are simply another trading phase, or symptomatic of some deeper anxiety.

 

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