OPINION 

Cliff hopes

Chris Dillow

Chris Dillow
Cliff hopes

Worries that the US economy might fall over the 'fiscal cliff' might provide a buying opportunity, according to new research.

Stig Moller of Aarhus University and Jesper Rangvid of Copenhagen Business School have found a negative and statistically significant correlation between US industrial production growth at the end of a calendar year and equity returns the following year. Since 1948, they estimate, falls in output in the fourth quarter have tended to lead to above-average rises in share prices the following year, especially for smaller stocks.

But this is only true for year-end growth. Changes in output in the other three-quarters of the year, they estimate, have no significant predictive power for returns.

This might - eventually - be great news for investors. Economists fear that uncertainty about fiscal policy is deterring companies from spending. There are already signs of this: non-transport durable goods orders have fallen since March, and business investment fell in the third quarter. This reluctance to spend might increase as we get nearer to the cliff, causing output to fall. Scott Baker and Nick Bloom of Stanford University and Steven Davis at the University of Chicago compile a daily index of policy uncertainty. They estimate that this is now three times its post-1985 average.

History suggests that, if this does happen, it could lead to shares rising next year. And not just US ones. Because equities are correlated around the world, a rise in the US market would benefit the UK. For example, on the last five occasions when US industrial output fell in the final quarter (1990, 2000, 2001, 2002 and 2008) the FTSE small cap index rose by an average of 11 per cent the following year - four times its average annual rise since 1989.

So, why does the fourth quarter's output growth predict returns? One reason, says Mr Moller, is that output changes at the end of the year are correlated with moves in consumer confidence and investors' sentiment. This isn't the case the rest of the year. This might be because the winter blues make investors unusually jumpy, and so more prone to react to good or bad economic news.

And, says Mr Moller, investors are more likely to rebalance their portfolios at the turn of the year than at other times. This causes them to be more likely to dump shares they regard as risky, with the result that shares that are hit by any drop in confidence and industrial production fall in price. This means they offer unusually big returns for the investors brave enough to buy them.

The lesson here for investors is simple. If worries about the fiscal cliff do hurt the economy in the next few weeks, we should heed the advice of a great man: "Don't panic!"

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