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OPINION

Markets are sun-bathing. So?

Markets are sun-bathing. So?
August 8, 2014
Markets are sun-bathing. So?

But it’s not just the sell-side: the buy-side, too, has every incentive to remain bullish - at least in the medium term. Results from Schroders (SDR) and Jupiter (JUP) last week offer a useful reminder that asset managers earn their keep by taking a cut of the assets they govern, and therefore thrive on money flowing into their funds. Schroders attracted £3.8bn from private investors in the first half, while Jupiter posted net mutual-fund inflows of £875m. They would probably not be receiving these inflows if they argued that assets were overpriced. Mr Smithers doesn’t write about "fund manager economics", but that’s presumably because he sells fund managers his advice - in competition with stock brokers.

So it’s always worth paying attention when long-only fund managers defy their sales teams to claim that stocks are dear. This is where Mike Felton comes in.

The manager of a £727m retail fund for M&G, which is owned by the Prudential (PRU), Mr Felton warns of a "bubble in complacency". He reckons economic and geopolitical risks are not being priced into markets. And he’s also concerned about growth. "Growth forecasts are coming down. The corporate spending recovery hasn't really happened. We've had a prolonged period of rerating in stocks, but very little earnings growth. We need to see that growth, but where is it going to come from?" He worries that "there is still way too much debt in the system".

Yet markets are full of summer sunshine. I have reproduced Mr Felton's favourite chart below. It’s an intriguing combination of the famous Vix - the so-called 'fear index' - with a more obscure index called Skew, also produced by the Chicago Board Options Exchange. Whereas the Vix measures the expected 30-day volatility of US stock market returns (as implied by options pricing), the Skew measures expectations of so-called tail risk. Put more simply, Skew tracks the extent to which investors and traders are using options to bet on - or hedge against - a big correction within the next month.

The interesting thing about these indices now is that the Vix is close to record lows, while the Skew is close to record highs. This is clear if you divide the Skew by the Vex to give the line below. What this shows is that investors, as I have noted before this summer, are "nervously complacent". On the one hand they expect calm trading conditions; on the other they are covering their backs.

Mr Felton, who on the M&G website shows the chart stretching back to the year 2000, is keen to point out this was also the case in early 2007. The snag in this argument - as I found out when I called up the data myself - is that the graph also peaked in the mid 1990s. In retrospect, this proved an excellent time to buy US stocks, even though they had been rising for years.

So is it 2007 all over again, or 1994? Let’s hope it is 1994, and a rush of investment stimulates a return to strong economic growth. In case it is not, however - and Mr Felton is right to point out that sources of growth are scarce - the more pertinent question is how to protect against a correction. Interestingly, Mr Felton is holding more cash than usual, but otherwise his approach is unchanged. He still tries to hunt out stocks that offer value, citing names as varied as insurer Lancashire (LRE), microchip maker CSR and - his top-conviction holding - hips and knees specialist Smith & Nephew (SN.).

That's a sensible starting point for digesting the glut of company reports we have written over the past week.