I had intended to issue Part 2 of the TopChop Psychology Blogs tonight but a couple of weeks ago I read an article from Chris Dillow (@CJFDillow on Twitter) from the Investors Chronicle dated 7 October - 13 October 2016 (the one with the front page title of ‘Supersize Returns: EUROPE’ and the stereotypical German funny hat and lederhosen……) and tonight I reread it and decided it was actually saying something quite important and worth us all thinking about. With the time critical nature of the Markets I felt it was more important to put this out at this juncture.
The article appeared on page 17 of the Printed Copy and is titled ‘Good returns, poor growth’, if you are a Subscriber to the IC you can read the full article here but I will just cut out a few key bits below for Readers to consider:
The basic premise Chris puts forward is encapsulated in this bit of text from the start:
“There's something odd about this year's rise in share prices: it has coincided with a weak US economy.
I say this is odd because there has for years been a close correlation between US industrial production and the All-Share index. It has been 0.61 for annual changes between 1995 and 2015, implying that fluctuations in US output growth alone can explain almost two-fifths of the variation in annual equity returns.
With US output now lower than it was a year ago, this relationship implies that the All-Share index should have barely risen at all in the past 12 months. In fact, it's up by more than 11 per cent.”
This chimes with my understanding and sense of what has been going on in the Global Economy and with Global Stockmarkets - we seem to have very slow or almost Stagnant growth in many Countries and Regions yet Shares Prices continue to charge higher - the US and UK in particular hitting or exceeding All Time Highs. In addition, from my years of experience, it has been pretty clear to me that Stocks can do well or at least just ‘OK’ when Economies are growing nicely but it is the Economic Slowdowns and in particular periods of Recession which really smash Stocks and lead to huge falls. We are clearly not in Recession but the more time that elapses since the last Recession implies that we are nearer the next Recession - and Growth is clearly below the trends of previous Decades.
Chris then goes on to give explanations as to why this disparity might be - I will put his text then a quick view myself below.
“One is when shares recover from being underpriced; this happened in 2003-04 and in 2009-10. I doubt this is relevant now, as few people claimed a year ago that shares were very cheap.”
I have to totally agree with Chris here. After a severe drop like we had in 2003 and 2008, Stocks were obviously screamingly cheap - since then we have had 6 years or more of a Bull Market and to claim that Shares are cheap would show a total lack of understanding in my view.
“Secondly, shares can rise during poor economic times in anticipation of faster growth - or perhaps even as a cause of it. This happened in mid-1998, 2005, 2009 and late 2013. Roger Farmer at University of California Los Angeles has pointed out that equities are a surprisingly good leading indicator.
This doesn't guarantee, of course, that equities will continue to do well. But it does point to the US economy picking up, which should at worst put a floor under the market.”
I personally find this hard to believe - as a Best Case Scenario maybe the US can grow nicely but this doesn’t really make much sense when you consider that other Major Economies seem under pressure. As examples, China has been slowing and no one can believe the figures anyway, Japan is a Comedy Country in economic terms (and possibly even a highly dangerous Monetary Experiment Petri Dish), Europe is stagnant, UK will suffer post-Brexit, Latin America is too Commodity dependent and riddled with bonkers Socialism, Russia is increasingly frozen out of Global Markets and the Middle East is as it usually is. For US to do well against such a backdrop doesn’t make much sense and it is worth noting the IMF etc. have recently downgraded Global Growth estimates - although clearly forecasts from any such Bodies are not particularly accurate or useful.
In addition, Central Bank Policies like NIRP (Negative Interest Rates) and continual rounds of QE (Quantitative Easing - essentially Money Printing and buying overpriced Bonds of dubious quality) are probably having the opposite effect to that desired by Janet Yellen et al and are exerting Deflationary forces upon all Economies where they are being pursued.
And one more thing - over the last year or so Western Economies have received a nice boost from low Oil Prices - in the last few months Oil Prices have recovered a lot and it is clear this could be a drag on growth.
“There is, however, a third possibility. Sometimes, rising share prices amidst weak economic activity is a sign that prices are unsustainably high. This was the case in 1999, 2006 and mid-2011.”
To me this makes the most sense - purely by very simplistic measures like looking at Historic P/E ratios and/or Dividend Yields for Major Indexes it is clear that Stocks are on the high side. Anecdotally, I see many, many Stocks on FORWARD P/E ratios of the high 20s like 28 or so and this is very unusual - and from the very basic sense that I see fewer and fewer really Cheap Stocks across the UK Markets makes me think that Stocks are on the Toppy side.
Chris then goes on to elaborate this point with a pretty incisive summary:
“We've a plausible reason to believe history might be repeating itself. Experimental evidence confirms what many feel - that poor returns on cash have caused some investors to 'reach for yield' and to take on excessive risk. This might have pushed share prices up too far.
Now, this is not to predict an imminent crash: overpriced markets can stay overpriced for longer than you think. What does seem clear is that the divergence between a strong stock market and a lacklustre economy might not last for very long. And while the gap could be closed by stronger economic growth, this is by no means certain.”
Now, seeing as I have disappointed so many Readers with my utter failure to deliver on the TopChop Psychology Blog tonight, I offer up this final piece of Psycho conceptualisation……..
In Chris’ piece he has mentioned 3 reasons which might explain the disparity between US Industrial Output and Share Prices - however, it brings in an important Psychology aspect which is referred to by Daniel Kahneman in his outstanding book, ‘Thinking, Fast and Slow’ (it is a tough read but extremely good and you can get a copy for Christmas from Wheelie’s Bookshop) as ‘What you see is all there is’ (WYSIATI) - which essentially says that our lazy and suboptimal Human Brains are all too willing to accept Information that is put in front of us and we don’t particularly bother to look for other pieces of Information that might be missing.
In this example, Chris has given us 3 explanations but maybe there are more. I have not spent ages thinking about this (mainly because Chris’ reasons are probably the key ones and I tend to agree with them) but maybe Readers would like to ponder on what other plausible reasons there could be for such a disparity. Anyway, one that comes to mind for me is that Extremely Low Interest Rates and ‘Financial Repression’ Policies (forcing Financial Institutions to buy ‘lower risk’ assets such as Bonds) are increasing the demand for Stocks - the only problem with this idea is how it basically means I am saying “This time it’s different” and Valuations don’t matter - but anyone with even a limited experience will probably have realised that whenever you hear “This time it’s different” you need to Sell your Stocks !!! (because it never is different - the Story always ends in the same horrible heap when people overpay for crappy assets).
And if you also bear in mind that the Interest Rate Cycle has probably reach the bottom now and the next moves are likely to be upwards (ok, they will most likely be very, very slow, but even tiny moves in Interest Rates could exert big downwards pressure on Bond Prices and have an adverse effect on Stocks simply as Investors get spooked by a sense that the Cycle has turned).
Another reason for the FTSE All-Share to have done well is the big drop in the £ since the Brexit Vote which has boosted the Share Prices of Companies which have large overseas earnings and has made the Shares cheaper for Foreign Investors. There are 2 difficulties here - firstly the Quid has got severely beaten up and it is very possible it can recover a lot of the lost ground in coming months - that might hurt the Stocks that have done well recently. Secondly, correlations like that between these recently rising Stocks and the Pound Weakness may breakdown - Correlations have a nasty habit of doing this (as Long Term Capital Management found out to their cost many years ago…..)
OK, that’s it, I hope it gives you something to ponder while I get to work on finishing this set of Psychology Blogs…..
See ya, WD.
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