The reason to believe this lies in the fact that investors' sentiment is still depressed. A good measure of this is the ratio of the Aim index to the FTSE 100. This is because Aim stocks are generally more speculative and less well-known than FTSE 100 ones, and so investors buy them when they are confident but dump them when they are depressed. A low ratio of Aim to FTSE 100 is thus a measure of depressed sentiment. And recently, this ratio has been close to its lowest level than at any time other than in the darkest days of the 2008-09 crisis.
This matters for everyone because sentiment helps to predict companies' capital spending. High sentiment in the tech bubble of 1999 led to an investment boom; the subsequent drop in sentiment led to investment falling relative to GDP; the levelling off of sentiment in the mid-2000s stabilised the investment-GDP ratio, and its slump in 2008 led to falling investment. You'd expect a lag between sentiment and corporate investment simply because it takes time for investment decisions to lead to actual spending, so capital spending this year reflects sentiment last year.
With investors' sentiment now depressed, this suggests the outlook for capital spending is grim. And this points to poor growth generally because traditionally companies that have not spent on capital equipment have tended not to hire workers, either, and weak hiring should depress consumer spending too.
You might think that such a grim prospect augurs badly for shares.
Not necessarily. It depends upon why sentiment predicts capital spending. In a rational world, it would do so because low sentiment means low share prices and hence a high cost of capital which naturally deters companies from investing.
Two things, however, suggest this is not the case.
One is simply that capital spending is very rarely financed by issuing equity. The other is pointed out on a new paper by Charles Lee and Salman Arif, two US economists. They show that higher levels of capital spending tend to lead to lower profits, GDP growth and to poor equity returns. This is true in 13 of the 14 developed economies they studied.
This is inconsistent with the idea that companies' capital spending is a rational response to growth opportunities. If this were the case, you'd expect investment to lead to rising profits and GDP growth, not falling.
Instead, it tells us that companies' investment decisions are motivated by the same waves of pessimism and exuberance that sometimes wash through stock markets. Irrational exuberance causes companies to invest heavily just before a downturn, and pessimism leads them to withhold capital spending even though prospects might be okay. Maynard Keynes, then, was right: capital spending is driven by "animal spirits" and "not [by] the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities".
And here's the good news for equity investors. Professors Lee and Arif show that low investment and depressed sentiment lead to rising share prices. Since 1997 there has been a negative correlation between the Aim/FTSE 100 ratio and subsequent two-year equity returns, with a low ratio leading to good returns and a high one to bad returns. Although this is only marginally significant for FTSE 100 returns, it is strongly so (minus 0.54) for Aim returns. This is consistent with sentiment being cyclical, so low sentiment is a sign of excessive glumness, with the result that shares rise as this excessive pessimism dissipates. Shares that are more sensitive to sentiment - such as Aim ones - benefit more from this.
For this reason, this year could be good for shares even though we suffer a weak economy, because both are a function of the same thing. The same depressed sentiment that causes companies not to invest is also a sign that investors are too gloomy and hence that shares are underpriced.
We could go further. As investors' sentiment improves from its low base, so companies' animal spirits should improve. This should lead to a pick up in capital spending in 2014 or 2015.
If we're really optimistic, we might go further still. If capital spending is driven more by sentiment than by a rational assessment of future prospects, then perhaps current low investment is a sign not of long-term stagnation and the end of growth, but merely of irrational pessimism which should eventually disappear. Perhaps, then, our longer-term prospects aren't as bad as we might imagine from looking at companies' reluctance to spend.
Personally, I suspect this might be stretching things too much. In fact, there might actually be a worry for investors in all this. If chief executives' investment decisions are swayed more by sentiment than by rational appraisal, what exactly are you paying them multi-million pound salaries for? And if they are irrational in this respect, in what other regards might they be so?
