In recent weeks we’ve seen shares slip and gilt yields fall. This can only mean one of two things – that investors have become either more pessimistic about economic growth, or more reluctant to take on risk (or a bit of both).
The distinction matters. If investors have become more risk-averse then the market should bounce back, because high returns should in theory be the reward for taking risks that others are avoiding. If, on the other hand, shares have fallen because of expectations of lower growth they will only recover if those expectations prove too pessimistic. Otherwise, lower future growth means lower dividends than previously expected, which should mean permanently lower prices.
How can we tell which it is? Theory says we should be able to do so by looking at high-beta stocks. If these underperform while gilt yields are falling, it is a sign that investors are becoming more reluctant to take risk. If theory is right that good returns are a reward for taking risk, this should lead to shares generally rising.
Sadly, however, the evidence for this is mixed. It is the case that falls in 10-year gilt yields over a six-month period more often than not lead to rises in the All-Share index in the following six months. But the correlation, while statistically significant, is modest at just 0.23 over the past 15 years.
Worse still, the link between the performance of high-beta stocks and subsequent returns on the All-Share index is the opposite to what theory predicts. Using my high-beta portfolio as a measure tells us that six-month periods in which high-beta stocks underperform the market are more likely than not to lead to the All-Share index falling rather than rising in the next six months. When investors become more reluctant to take on market risk, it is a sign not that shares generally are about to recover, but the exact opposite – that they could fall further.
This contradicts conventional theory. It is, however, consistent with other evidence. Andrew Lo at the MIT, and the UCLA’s Tyler Muir and Alan Moreira at the University of Rochester, have separately shown that rises in market volatility tend to lead to shares falling. This implies that it does not pay to take on risk when others are avoiding it. This is consistent with the bold claim made by Eric Falkenstein at Pine River Capital Management that there is actually no correlation between risk and return.
We can, however, salvage the theory. There’s one indicator that does have some predictive power. It’s the performance of high-beta stocks relative to value stocks (as measured by my high-yield portfolio). When beta underperforms value, the All-Share index tends to subsequently rise: since 2004 the correlation for six-month changes has been 0.35. Poor performance by high-beta stocks relative to value in 2012, late 2014 and mid 2016 all led to the All-Share rising, while outperformance by high-beta stocks in 2008 and early 2018 led to it falling.
What’s going on here is straightforward. Deep value stocks are a barometer of investors’ expectations of near-term growth prospects; their collapse in 2008, for example, was a harbinger of recession. If they hold up while high-beta stocks fall, therefore, it is a sign that investors are comfortable with growth prospects but are more risk-averse. And this should (and does!) lead to shares generally rising, as that risk aversion dissipates.
Herein lies some good news. In the past six months high-beta stocks have indeed underperformed value, implying that aversion to market risk has risen while attitudes to growth haven’t changed much (albeit by remaining downbeat). History suggests this is the combination that tends to lead to equities generally rising.
Granted, this indicator, while statistically significant, isn’t very powerful. But it is consistent with two other bullish indicators. One is that we’re approaching the time of year when equities traditionally do well. The other is that the dividend yield on the All-Share index is well above its longer-term average.
It might not feel like it, therefore, but there are reasons for equity investors to be mildly optimistic.
