The Emperor's New Clothes
In the investment industry idioms abound. Everyone loves a new catchphrase as it generates interest and appeals to our curiosity.
In 2016 several new words appeared that have already made an enormous impact not just on the investment landscape but politically and economically. “Brexit” and “Trumpism” are two words that are stirring emotions and passions across the world.
A phrase that continues to fascinate me has been around for a long time and is regularly used by economists and investment professionals. The phrase is “priced in”, for example; “the markets have already priced in a potential interest rate rise”.
With global stock markets rising and the UK and US markets at record levels, we are now being told that the rally should continue because; in the US the markets have “priced in” increased infrastructure spending, corporate tax reductions and banking reform. In the UK markets have “priced in” a softer “Brexit” than was first predicted. In China, markets have “priced in” a successful switch from manufacturing to consumer led growth.
What’s interesting is the fact that none of these events have happened yet. We don’t know when, or even if, these events will play out as predicted. During an uncertain and often turbulent 2016 virtually all “expert” predictions turned out to be wrong!
“Pricing in” means that markets are reacting to a series of future outcomes. What happens if some or all of the forecasts fail to materialise? “Pricing in” to me suggests; “counting your chickens before they have hatched”. This is why markets continually outperform or underperform expectations.
Rising equity markets attract investors and as markets continue to rise, so does investor confidence. Despite US and UK Equity markets being at all-time highs, people are still being attracted by the strong returns that have been achieved over recent months.
The question for investors now is “will the strong stock market rally continue?”
It is worth noting that UK and US stock markets have been on a strong run since 2009, just after the global financial crisis. With savers being denied interest on deposits and government bonds becoming more expensive, stock markets have been the major beneficiaries of investors seeking income. Government and Central Bank stimulus, such as “Quantitative Easing”, has flooded markets with cheap money. As a result, it has become impossible to accurately assess the true value of most investment assets. As the saying goes; “A rising tide floats all boats”.
Whilst equity prices have risen in many sectors, company profits have failed to keep pace. This is borne out by the fact that many shares are now trading at very high price to earnings ratios. In the US, on average, stocks are trading on a P/E ratio of 26.5 times, whilst the long term average is 16.7 times.
I have no doubt that a global economic recovery is underway and may be sustainable. However, although there are other factors that are driving markets that should be considered, it is clear that investor momentum has played a part.
Brexit has caused a fall in the pound and that has boosted exports whilst increasing the profits of many FTSE100 companies. Large UK companies that have overseas operations have seen their overseas profits soar purely because the dollar has strengthened against the pound. If the pound strengthens will this trend be reversed? Also, has the increase in exports resulted in increased sales in the importing countries, or, are buyers stock piling while prices are low? If so, will exports stall when prices increase?
I remain optimistic about the long term outlook for global equity markets, however, I think that a cautious approach is required. In the short term, Europe is faced with general elections, Brexit and Greek debt. In the US, trade agreements, infrastructure spending and reduced corporate taxation has to be balanced against rising government debt. China has to try and rebalance its economy whilst avoiding a trade war with the US and controlling its currency. The UK has to negotiate withdrawal from the EU and seek new trading partners across the world.
These are all challenges that can be met, however, they also create uncertainty and investors and markets do not like uncertainty. Although investor confidence remains high volatility is likely to return and when it does many investors will rush for the exit door!
One interesting fact appeared on Bloomberg news recently and went almost unnoticed. In the US CEO`s are no longer buying shares in their own companies, whilst company share “buy backs” have slowed considerably. Could this be because they see the Emperor differently than the rest of us?
At A&M Wealth Management Ltd, we continue to recommend profit taking for existing investors and the“phasing in” of new money during periods of volatility. This approach may limit short term growth but should improve long term value!