We know that UK equity returns are partly predictable by using lead indicators such as the dividend yield, foreign buying of US equities and the ratio of the money stock to share prices in the developed world. The same is true for overseas equities – and lead indicators which have worked well in the past point to a big rise in prices this year.
My chart shows the point. It plots annual changes in MSCI’s world index in sterling terms against the changes predicted by a handful of leading indicators. I stress these are lead indicators: I’m using data in (say) December 2017 to predict the annual change in the following 12 months. These indicators explain three-fifths of the variation in annual returns since 1997.
The indicators are:
- Foreign buying of US equities in the previous 12 months. Big buying is a sign of bullish sentiment. It predicts falling prices over the following 12 months because such strong sentiment does not usually persist for long.
- The ratio of the money stock in the Organisation for Economic Co-operation and Development (OECD) countries to MSCI’s world index. When this is high relative to its trend it is a sign that investors have lots of cash and few equities in their portfolios, which implies they are likely to rebalance their portfolios towards equities. And when they do, prices will rise.(And vice versa when the money-price ratio is low).
- The dividend yield on the S&P 500. High valuations on the world’s largest stock market lead to rising prices for overseas equities in total.
- The ratio of the MSCI world excluding UK index to its 10-month moving average. The higher this is – other things equal – the better the prospects for the market. This reflects the fact that equities are driven by momentum. It captures the advice of Meb Faber at Cambria Investment Management, to buy when prices are above their 10-month average and to sell when they are below it.
- US interest rates. The higher are 10-year yields relative to five-year ones the higher are subsequent returns. This captures the tendency for the yield curve to predict fluctuations in US output and hence in global share prices.
Naturally, we would not expect these indicators to work perfectly: there are always some surprises. These predictors were too pessimistic in 2005 and 2011 and too optimistic in 2002 and 2008-09. Often, though, the errors are in the right direction. In December 2007 for example our indicators predicted a 13 per cent drop in the market in 2008 but in fact prices fell 18.4 per cent. Our indicators were sending a bearish message, which surely was useful.
Our indicators work to a large extent because they measure investor sentiment. When this is high, good news is priced in and bad news not. This means that surprises are more likely to disappoint investors than please them, which means prices are likely to fall. Conversely, when sentiment is low investors are more likely to be pleasantly surprised, thus pushing prices higher.
Our indicators now point to a big rise in priced this year – of almost 30 per cent from December 2018 to December 2019, although we’ve had seven percentage points of this already.
I confess I find this surprising: I don’t feel that bullish. But it’s what the data say. We saw heavy selling by non-US investors of US shares last year. That’s a bullish sign. So too is the fact that 10-year yields are above five-year ones. And the fall in share prices late last year raised the money-price ratio to its highest level since 2016. That removed a bearish indicator.
Of course, we wouldn’t expect the outlook to remain so bullish. If prices rise a lot then the money-price ratio would fall, which would be a bearish signal. And we’d expect rising prices to inspire foreigners to resume buying US equities, which would weaken and then remove our most bullish indicator. It’s through mechanisms such as these that equity returns tend to be cyclical.
We should also watch five-year US yields: a rise in these relative to 10-year yields would be worrying.
I don’t read this merely as a bullish story. I read it also as a hypothesis to be tested by events. If we do get anything like the recovery predicted here it would show the virtue of basing our decisions more upon algorithms and statistics and less upon subjective judgment.
