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Lead indicators turn rosy for Footsie

Created:
1 July 2008
Written by:
Chris Dillow

Three traditionally useful lead indicators of equity returns have sent bullish signals this week.

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The Investment Management Association reported that sales of unit trusts fell to just £91m in May (after £2.3bn in April), as institutional investors sold them heavily. Low interest in unit trusts has in the past led to rising share prices in the following 12 months, as investors tend to avoid shares just when they are the cheapest.

Also, although the Bank of England's report that mortgage approvals have fallen to their lowest level since data began in 1993 augurs badly for house prices, it's encouraging for equities. Since the Bank's figures began, there has been a significant correlation (minus 0.24) between the level of mortgage approvals and subsequent annual changes in the All-Share. This is because if people are too nervous to lend or borrow against housing, they are usually nervous about shares, too. And high risk aversion predicts high returns.

Thirdly, the Bank of England reported that financial institutions' cash holdings continued to grow in May. They have risen 18 per cent in the last 12 months, and by 2.9 per cent in the last three. Rights issues are not (yet) seriously depleting institutions' cash piles, which are now equivalent to 30.8 per cent of the All-Share's market capitalisation, almost twice the average ratio of the last 15 years.

Common sense says that when there's lots of money and relatively few shares, prices should rise.

But common sense has been wrong lately. Institutions' cash piles were high a year ago, but this did not stop the shares falling. And economists suspect some of the recent growth in cash holdings reflects not money available for share purchases, but rather the fact that banks have put money into their off balance sheet structured investment vehicles to make up for losses on mortgage derivatives.

However, the other two lead indicators of returns have shown less sign of breaking down recently. With hindsight, we know that the high level of mortgage approvals in the spring of 2007 successfully warned us of awkward times ahead for shares.

One of the first rules of investing is that the time to buy risky assets is when others don't feel like doing so. And most indicators suggest that the appetite for risk is quite low now.

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