Nick Dewhirst looks at the historic data that should help investors predict the shape of the stock market over the next couple of years
The big surprise in the second quarter was not that US interest rates finally began rising, but that almost every type of investment strategy generated losses as a result.
Does this mean that the global bull market is over and investors should dash for cash?
It is logical that US bond prices fell, and understandable that US shares suffered a setback as a result, but why should European and Japanese markets also experience setbacks when their interest rates remain unchanged and why should hedge fund strategies be affected? Surely at least some kinds of hedging strategy should be profitable, but they all lost money in May (see chart one).
Have all financial market been infected by speculators borrowing US dollars at record low interest rates to re-invest elsewhere? If so, should one worry about a new global bear market? If this is the damage caused by a quarter point rise in Fed funds, how much worse can it become, when rates rise further? If real rates are still -1.25%, what should investors expect when they return to neutral, let alone become positive again?
In the short-term this is likely to shake out highly leveraged investors, but that is good news. Assets will flow from weak hands to strong hands. The well financed can afford to sit out short-term uncertainties. Even when a shake-out hits such a major league player as Long Term Capital Management the damage can be quickly repaired. Then Wall Street made up all its 12% loss during August and September by the end of October 1998. Indeed, it appears that this process is already beginning.
Secondly, it is worth noting that traditionally it has been politically incorrect for chairmen of the Federal Reserve to take drastic action in the run up to an election, so past history suggests that US investors have a few months longer before they need worry. Anything other than a broadly neutral position on interest rates could be considered as politically biased, because of the obvious effects on confidence of investors in their capacity also as voters.
According to an old stock market adage there are three hikes before the stock market takes a tumble. The first has only recently happened and the third still lies in the future. Past experience, therefore, suggests that there are still a few months to go before the need to worry seriously.
However, long-term investors are well advised to re-evaluate their positions by going back to first principles and the first principle of equity investment is that the level of share prices is determined by two components - corporate profits and a valuation ratio. Specifically this can be defined as P = P/E x E, where P is the level of overall share prices, P/E is the price/earings ratio and E is earnings per share.
After two decades of a secular bull market, it is all too easily forgotten that rising interest rates have two opposing effects on the traditional stock market cycle. On the one hand, since the P/E ratio is merely the reciprocal of the earnings yield, this component will respond to competition from bond yields, which are normally driven the same way as interest rates by the same factors. Thus rising interest rates tend to depress valuations. On the other hand interest rates normally only rise because economic activity is improving, and that generates higher corporate profits. Indeed the very inflationary fear that causes interest rates to rise, is precisely the situation where profit margins improve because companies regain pricing power.
Thus the outcome for the stock market depends on the balance between these two effects. If a decline in the P/E ratio exceed the rise in EPS, the market falls, if not it rises. Typically the balance is initially favourable, but progressively negative. During the 1960s and 1970s, the stock market behaved in such a cyclical manner. Typically bull markets suffered an intermediate correction, before resuming for one final upwards push.
Success for investors in that second part lay in identifying those sectors where rising profits were more important than falling valuation ratios. I suspect that the situation is now similar. This means that it is no longer an easy time to make money, because investors will be focusing their remaining free funds on a dwindling number of economic sectors and investing styles. In order to succeed, investors will have to choose the right specialist funds at a time when broadly-based generalist US funds may well prove lack-lustre.
For the record, my most recent econometric modelling suggests that EPS will grow by 28% this year but by only 1% next year. Rising GDP and a weak exchange rate combine to make this year excellent, but next year these factors are unlikely to be so positive. Sadly, investors normally focus on the likely outcome for the next year, so this is not encouraging, especially as my top-down forecasts are more pessimistic than the bottom-up aggregates of the brokerage houses. Simultaneously both short-term interest rates and long-term bond yields are expected to rise, according to Consensus Forecasts. The combination strongly suggests a bear market on Wall Street in the near future.
Those who believe that the US is the centre of the universe may mistakenly draw the conclusion that what is bad for General Motors is bad for the world. As mentioned initially, it is notable that while short-term US rates are rising, Japanese rates remain at virtually zero and European rates are barely changed. For students of cycles this is hardly surprising as the Japanese economic recovery began a year after that in the US and Europe is a year behind Japan (see chart two).
This is shown up clearly in my analysis of capacity utilisation, aka output gaps. While calculations used by Investors RouteMap are broadly similar to those of the IMF and OECD, our coverage is much broader, as it includes also many emerging markets. Chart three shows shows the two trends were broadly similar through the recessions of 1974-1975 and 1980-1982 but, subsequently, and despite increasing globalisation, there has been significant divergence.
According to my forecasts, the US is operating at levels of capacity utilisation approaching previous peak levels, while the rest of the world is still operating well below average levels. Europe is accused of sclerosis, Japan might be coming out of its decade-long depression and other Asian markets have still to recover completely from their 1997 crisis.
The Japanese bubble and its aftermath provide an instructive parallel. US-centric investors should note that while the US accounts for approximately half the world's stock market capitalisation, so did Japan at the peak of its bubble in 1990. See table two.
As this chart shows, while Japanese shares are still worth little more than half their peak value 14 years later, the rest of the world's markets have provided many alternative profitable investment opportunities. In particular US shares quadrupled and still stand at three times their value in 1990. Both series are converted into common US$ for comparability.
Thus investors will have to be increasingly selective, not just in their choice of sectors and styles but also of countries and regions. As many global managed funds have been exposed as little more than closet-index-linkers, the conventional response of investors has been to search to alternatives to equities, which is likely to drive down returns among such alternatives. As the conventional approach is seldom rewarding in matters of investment, I suggest instead that an unbalanced portfolio of specialist equity funds may well be more profitable and prudent.
Two global vehicles
'Further plug advice gap'
Must appoint separate CEOs and boards
Advisers do come out well
Will report to Mark Till