Anybody wanting a clue to where share prices are going this year will get one next Thursday – and it might not be pretty.
The US Treasury will then release its latest data on capital flows. What matters for investors in these is the net foreign buying of US equities, because this has for years predicted annual changes in the All-Share index, and indeed changes in global share prices generally. Big buying in 1999-2000 and in 2007 led to prices falling in the following 12 months, while light buying or net selling in the early 2000s, 2008 and 2012 led to rising prices.
In saying this, I’m not speaking only with the wisdom of hindsight. Back in 2007 I wrote that record foreign buying of US equities pointed to the market falling sharply. That was not wrong.
Of course, no lead indicator is perfect. Equities did worse than foreign buying predicted in both 2002 and in 2015-16.
Overall, though, there is some predictive power here – about as much power, in fact, as the dividend yield has. Since January 1998 the correlation between foreign buying of US equities over a 12-month period and the annual change in the All-Share index in the following 12 months has been minus 0.45. The correlation between the dividend yield and subsequent annual changes in this time has been 0.48. If you believe valuations matter for returns – and you should because they do – the statistics therefore tell us that you should also believe that foreign buying matters.
There’s a good reason why it should. Investors usually prefer to buy stocks they feel familiar with – ones close to home. Economists call this the home bias. It is only when investors are very confident that they buy overseas stocks. High confidence, however, is often unsustainable. And as it falls, so too do share prices.
And here’s the problem. Non-Americans have recently stepped up their buying of US stocks; in the year to October they bought $68.1bn (£50.3bn) of them, which is slightly above the average of last 20 years. If post-1998 relationships continue to hold, this predicts that the All-Share index will rise only 4 per cent from last October to next October – and we’ve already had three percentage points of this rise. To put this less precisely but more accurately, it suggests that the chances of the market rising over the next 10 months aren’t much better than 50:50.
Of course, this is only one lead indicator. The dividend yield on the All-Share index is still above its 20-year average, which points to better returns. And prices are also above their 10-month moving average which also augurs well. But on the other hand, the ratio of global share prices to the global money stock is high, which is a worrying sign.
On balance, unless next week’s figures tell us something very different from what they’ve been saying recently, leading indicators are warning us that 2018 will be a tricky year for equities.