What drives markets mostly comes down to three things: in the short term, liquidity and momentum; in the long term, valuation.
Look at most markets today through that prism, and it isn’t a happy picture. There is still plenty of liquidity – Japan is just getting started with real quantitative easing (QE) and Europe has a way to go. But in America there are increasing hints that there will at some point be some “tapering” of QE.
It’s hard to see how that will happen – as David Stockman explains here – the Fed is backed into a bit of a corner. But the fact that it might is enough to make any bets on markets not quite as ‘one-way’ as they have been in the last few years.
On to momentum. Look at global economies and you won’t see much of this about. I listened to Pictet’s Luca Paolini speak this week on asset allocation. One thing he pointed to was the way in which leading indicators of economies are pointing mildly downwards (for those who are interested, what he actually said was “global PMIs are converging at 49”). Then there are valuations. Regular readers will know that while we aren’t ready to call today’s equity markets a proper bubble (unlike Stockman), we do keep noting that they aren’t cheap on our favoured measure – the cyclically adjusted price/earnings ratio (Cape).
However, Paolini produced an even more frightening chart than the ones we are used to. It looks at the US price/book-value ratio relative to its trend level, and its performance after it sees a sharp rise. Every time since 1980 that it has moved more than two standard deviations (SD) away from trend, the market has fallen sharply – by 9%, 17%, 13% and, most recently, by 40%. Today it has crossed over the two SDs line again.
Not long ago, says Paolini, liquidity was plentiful (and its ongoing supply was not in doubt), markets were cheap, and there was an impressive flow of improving economic news. You can’t say any of those things are particularly true any more. For Pictet this doesn’t mean being very bearish. From its point of view, there is nothing very absolute about valuations. You can pick any method of valuing stocks you like to back up any case you might have. For Pictet at the moment, that method is to look at equities relative to bonds – in which case equities are neither cheap nor expensive.
Anyway, as far as professional investors see it, you have to be invested and equities are the “least bad” of the over-priced asset classes out there. This is all true. But I still think that as non-professional investors we can be a bit more absolute. We don’t have to be short-termist. We don’t have to be relative. And we don’t have to hold equities anywhere in particular. We can look at the fact that the price/book ratio in the US is out of whack with its long-term trend, or that the Cape is at danger levels, and either look for cheaper markets (Russia?), or just keep a larger percentage of our money than usual in cash instead.