A few months ago I went to a talk at a conference in Japan about ‘big data‘ – the way in which we can use the endless reams of information collected by companies and governments to improve the way we arrange our lives and businesses.
The example that stuck in my mind afterwards was that of doctors working with premature babies in Canada. Enter a neonatal ward and you will see and hear dozens of monitors all collecting various bits of information about the tiny patients’ vital signs – their pulses, respiratory rates and heart rates.
In most hospitals, when the baby leaves the ward, the information is discarded or ignored. At the Hospital for Sick Children in Toronto, it isn’t. Instead, it is analysed on a series of servers in an attempt to find trends that might be a precursor to a blood infection.
It works. The data shows that some 24 hours before showing signs of infection the babies’ heart rates show a reduced variability – they stop rising and falling over a day and become remarkably regular. So if you keep a baby hooked up to a monitor and keep the monitors hooked up to a data server you should, in theory, be able to recognise danger early.
The important thing here is that the time to take action is when things look just fine – not when the fever actually starts.
I thought of this again this week when I saw headlines in this newspaper announcing that volatility in the markets has been all but abolished. It’s all calm on the surface. There’s been no depression; no major failures in the eurozone; capitalism hasn’t collapsed in the wake of the global banking crisis; and the world’s central banks all seem to be working as one on the provision of long-term super-easy monetary policy. Even the European Central Bank has now clearly accepted its role as lender of last resort in Europe.
The result is stock markets pushing to new highs and borrowing costs for everyone – European countries included – sliding to record lows. We have what you might call a bull market in complacency. A recent survey, pointed out to me by Paul Niven of F&C Asset Management this week, showed that some 30% of market participants “see no catalyst for a rise in implied volatility in the next six months”.
You could see this as an entirely rational response to a newly benign environment, one in which not much is likely to go wrong. Or you might note that as a line of thinking it contains pretty serious contradictions, and make a mental list of things that might cause a rise in implied volatility.
There’s no shortage of candidates. Here’s a few.
There’s a possible Chinese implosion (economic or social) as property prices fall and growth moderates. There is the horribly overpriced global property market, something the IMF now considers to be a major threat to economic stability. There’s the possibility of political disunity in the West – in the UK the separatists in Scotland are strong and in Europe the row over local democracy and accountability is surely only just beginning. US corporate profits are looking as though they may have peaked. There is also growing recognition that US profits might not be all they seem. The corporate sector holds large amounts of cash overseas: if they ever bring it home they will pay tax on it. Is cash subject to such huge repatriation costs really cash at all?
Then there is the intriguing chance that global interest rates start to move sooner than everyone thinks. In the US, as Simon Pritchard of Gavekal notes, there has been a “quick switch from flirting with deflation to watching prices push higher”. You can’t dismiss the possibility of a 1994-style pre-emptive move by the Federal Reserve on rates. That would have serious implications for a “bond market that is hardly priced for inflationary growth” to say nothing of its impact on the US consumer.
Consumer debt is now rising at a faster rate than it has since 2007. We don’t want to get too comfortable with our bizarre interest rate environment in the UK either – with the base rate still at 300-year lows the obvious way is up. Even Mark Carney, hitherto fairly dovish, is now suggesting that “the first increase could happen sooner than the markets currently expect”. There’s a threat for you.
What can investors do to recognise the problems with the contradictory calm in the markets? I hate to forever be giving you the same answer, but the key is to recognise this as a risky time not a benign time; to hold a cash buffer; and then to look for the insurance you get by buying assets at prices that represent some value. Thanks to the endlessly distorting effects of quantitative easing, there aren’t many such assets about at the moment (although some readers will have done well out of following me into very cheap Russian stocks).
But I do think that anyone beginning to doubt the merits of the Japanese market might have another look. It was everyone’s favourite at the beginning of the year but hasn’t exactly lived up to expectations. The average company on the Topix index is now priced at about book value and the market is also – for the first time in my now rather long career – cheap in terms of its price/earnings (p/e) ratio.
Look at individual companies and you will find the same. The Japanese vehicle manufacturing sector has, for example, fallen some 8% this year. But research from Pelham Smithers Associates shows the likes of Toyota and Nissan trading on p/e ratios of nine to ten times. Look at this in terms of the ratio of enterprise value to operating profit (a slightly more sophisticated version of the p/e ratio that includes debt as well as equity) and they are priced at not far off half their historic averages – and that’s with promises of more market-boosting quantitative easing to come. That isn’t something you will find in many other markets.
• This article was first published in the Financial Times