Buying warning

The outlook for UK equities has worsened, and the market will probably fall over the rest of this year, according to one powerful leading indicator.

I say this because figures released by the US Treasury last week show that non-US investors were big buyers of US shares at the end of last year. They bought $25.9bn of shares in December, taking their cumulative buying in 2012 to $102.1bn, the highest amount since the 12 months to August 2011.

This matters because foreign buying of US shares over a 12 month period is strongly associated with the change in the All-share index in the following 12 months. Since January 1995, the correlation between the two has been minus 0.64, which means that variations in foreign buying of US shares can explain two-fifths of the subsequent variation in UK equity returns. High foreign buying leads to low returns, and low buying to high returns.

There's a simple reason for this. Investors usually have a "home bias"; they prefer to buy domestic shares. They will only therefore buy foreign ones if they are unusually confident. But such high confidence is often a sign of excessive exuberance and thus of excessively high global share prices.

Big foreign buying in 2000 and 2007 led to shares falling in the following 12 months, whilst modest buying in the mid-00s and in 2008-09 led to rising share prices.

If the post-1995 relationship continues to hold, the foreign buying we saw in 2012 points to the All-share index rising just 1.3 per cent this year.

This is a problem, because the index has already risen 7.6 per cent. This means that foreign buying points to prices falling from now on.

Of course, foreign buying is not the only leading indicator of returns. But the picture doesn't improve much if we add the dividend yield. Taking this and foreign buying together as predictors leaves us with the same prediction - that the All-share will fall a little over the rest of this year.

So, is there any hope for shares? Yes. The relationship between foreign buying and subsequent returns is, of course, noisy. No means of predicting returns is perfect. Such noise implies that there is still a roughly 27 per cent chance of the market rising over the rest of this year, and a one-in-six chance of it rising more than five per cent. This is a chance, but only a chance. The odds are against the market rising this year.

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