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By Ross Garrad from Ravenscroft
THERE is an old saying that markets are driven by two emotions: fear and greed. While there are many other factors involved, these are two very powerful emotions when it comes to wealth. Everybody likes making money and most rational individuals don’t particularly like losing it.
Like many other living creatures, humans display a herd mentality in many areas of our lives. Think football games, general strikes and political voting to name a few. Herd behaviour can be more pronounced in emotionally charged, riskier or uncertain times. The “fight or flight” response often overrides more rational long-term thinking. For example, in a fire, individuals may all herd to the same overcrowded fire exit, perhaps overlooking alternative or less used exits, a behaviour known as “escape panic”.
By definition, equity markets are uncertain. One is trying to ascribe a price today to the likely returns to be delivered many years into the future. When people are optimistic about the future, they will pay a higher price but when they are pessimistic, they will be less inclined to buy and the clearing price will be lower. They will also typically be less patient, placing greater emphasis on short-term negative newsflow and perhaps ignoring longer-term structural growth themes or the normalisation of economic cycles. These emotions can have a drastic impact on investors’ portfolios and the stability of the wider stock market or economy as a whole.
UK equity funds have suffered 27 consecutive months of outflows, perhaps not a panic but an extremely long period of escape, which is undoubtedly damaging to the UK economy. Numerous companies are redomiciling to the US and, when combined with regular mergers and acquisitions (16 companies >£100m acquired this year), the FTSE All-share has suffered a decade of de-equitisation.
With only one IPO (initial public offering where shares of a private corporation are offered to the public) of note over this 27-month period, IPO activity has also ground to a halt. For one of the world’s most entrepreneurial nations not to offer a route to market for its entrepreneurs is a crisis. But a crisis spurs action and Chancellor Jeremy Hunt is seeking to encourage Europe’s largest pension industry to take more risk and invest up to £75bn in higher-growth businesses.
Today, financial markets hang on every word of central banks and mere words are causing heightened volatility, but this is not anything new. Amid very fearful markets in 2012, ECB president Mario Draghi stated the central bank would do “whatever it takes” to preserve the euro, spurring one of the longest bull markets in history for both bonds and equities.
In 1996, Federal Reserve chair Alan Greenspan famously uttered even fewer words – a “irrational exuberance” – which immediately reduced the value of global equities by over 3%. As it happens, fear was quickly supressed and greed continued for another four years before the dotcom bubble burst in 2000/01. It is worth reminding ourselves why this exuberance had appeared in the first place.
In Greenspan’s words: “Clearly, sustained low inflation implies less uncertainty about the future, and lower-risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
Ultimately, Greenspan was right, and it would have paid for investors to become gradually more fearful as risk premiums reduced and share prices continued to rise. History never repeats itself but it does rhyme and so we find ourselves, in the 2020s, with inflation returning to the fore and much higher risk premiums than we have seen for decades. The result of which has been a poor period for equity market performance, if one excludes the so-called “Magnificent Seven”.
The Seven’s impressive performance has largely been driven by “multiple expansion” – ie their shares becoming more expensive, the opposite of what is happening in the remainder of the market and what would be expected when higher risk premiums prevail. Perhaps the moniker itself smacks of “irrational exuberance” just as the “Nifty Fifty” and others have before.
Greenspan referenced Japan, actually a top performer this year but a stock market which suffered lost decades after its 1989 crash. The crash was caused by the Bank of Japan raising interest rates steeply to keep inflation in check and deflate speculative bubbles. Japanese equities underperformed for decades thereafter, partly because of a weak Japanese economy but mostly because their starting valuations were very expensive, as shown on Chart 1 below.
Historic CAPE® Ratio by country
This chart compares the Cyclically Adjusted P/E multiple for Japan, the UK and USA. CAPE was devised by renowned American economist Robert Shiller and is a remarkably accurate predictor of future returns. Emotion should have no place in investing and, when taking it out of the equation, one can see that equities deliver much higher returns when purchased at lower earnings multiples and much lower returns when purchased at higher multiples, a linear inverse correlation. This is demonstrated in the chart below.
Those fearful of UK equities and greedy about the US should be warned that the current US CAPE ratio of 28 is near double that of the UK. Should this linear relationship remain, UK equities would be expected to deliver returns of 15% per annum over ten years, while the US only 6%. A good time to be both greedy and fearful.
Sources: Barclays, Case-Shiller, Alan Greenspan, Peel Hunt
FINANCIAL PROMOTION: The value of investments and the income derived from them may go down as well as up and you may not receive back all the money which you invested. Any information relating to past performance of an investment service is not a guide to future performance and may not be repeated.
