Equities are heading for a fall. That’s the message of figures released last week by the US Treasury.
These showed that non-Americans bought $157bn of US shares in the 12 months to July, close to the largest amount since 2011.
My chart shows why this matters. It shows that foreign buying of US equities over a 12-month period has been a decent lead indicator of changes in the All-Share index in the following 12 months. Big buying in 2000, 2007 and 2017 led to shares falling, while selling in 2011-2012 and in 2015-2016 led to nice rises.
For the US market, foreign buying or selling has been an even stronger predictor. Since 1996 the correlation between it and subsequent annual changes in the S&P 500 has been minus 0.4, compared to minus 0.31 for the All-Share index.
There’s a reason for this. Traditionally, equity investors tend to stick disproportionately to equities in their domestic market, or even to companies with a head office near their own home or to those in the industry they work in. They have a home bias. It is only when they are unusually confident that they will buy lots of foreign stocks. Such confidence, however, is often a sign of over-optimism, which happens when shares around the world are over-priced. And so equities tend to fall in the following months. It’s no accident that the biggest foreign buying of US equities came in 2000, at the peak of the tech bubble, and in 2007 at the peak of confidence in the “Great Moderation.”
Theory and history, therefore, are warning us that global and UK equities are heading for trouble.
Anybody who is bullish of the market thus faces a challenge: why might this lead indicator now be wrong?
Certainly, it has gone wrong recently. Last year, foreign investors were big net sellers of US shares. That pointed to equities doing well this year. But of course, the All-Share index has not done so.
In itself, this might not tell us much, however. We cannot infer that this means the relationship has permanently broken down. UK equities have fallen (largely?) because of the effects of the pandemic. But this was a genuine bolt from the blue that nobody could reasonably have predicted. The failure of this lead indicator to call the market this year might therefore be a one-off.
There is, though, a better hope for the bulls. Perhaps foreign buying of US shares is no longer a sign of high investor sentiment.
Overseas investors are not buying obscure widget-makers in Hicksville, Nebraska but rather some of the world’s most high-profile companies such as Apple (US:AAPL), Amazon (US:AMZN) and Microsoft (US:MSFT). Such companies are perceived as being familiar and therefore relatively safe. Buying of these might therefore be a sign not that investors are unusually exuberant and overconfident but of the exact opposite, that they are being cautious. If this is the case, then it is a sign that sentiment is depressed, which should predict rising share prices in the next 12 months.
Personally, I’m in two minds about this explanation. It makes theoretical sense, but there is as yet no hard empirical evidence for it. Only time will tell.
Equity bulls do, however, have other reasons for hope. Other lead indicators are much more positive. The dividend yield on the All-Share index is well above average, and in the past this has been a great predictor of longer-term returns. Granted, the trailing yield is flattered because it doesn’t factor in upcoming dividend cuts. But even allowing for these, the yield is still encouraging.
Also, the ratio of retail sales to the All-Share index is high, which tells us that households are looking forward to better times. This too has been a great lead indicator of medium-term returns, and points to the market doing well even if we allow for some slip-back in spending as pent-up demand fades away.
We do therefore have good reasons for optimism. But these are not wholly strong. For me, this is a case for being cautiously bullish, and for having a decent holding in safe assets alongside our equity portfolios.
