There are several reasons to be wary of equities right now. The dividend yield on the All-Share index – traditionally a great predictor of medium-term returns – is below its long-term average; the rise in Aim shares suggests that sentiment is too high; the global ratio of share prices to the money stock is above average, suggesting that investors have lots of equities and little cash in their portfolios; and of course we’ve entered the wrong time of year for the market.
Whenever we face an apparently strong case, however, we must question it. Hence the question: what reason is there for optimism about the market?
One is simply momentum. The All-Share index is above its 10-month (or 200-day) moving average. The rule proposed by Meb Faber at Cambria Investment Management therefore tells us to be in the market. And an investor who had followed this rule in the past would have enjoyed high returns and lower risk than a buy-and-hold investor.
But there’s another reason, shown in my chart. It shows that since 1998 there has been a significant correlation (of 0.54) between annual changes in manufacturing output and annual changes in share prices adjusted for inflation. Falling output in 2001-02, 2008-09 and last year all saw equities fall, while decent output growth in 2006, 2010 and 2016 was accompanied by rising share prices.
Now, some of this correlation is simply because recessions come as nasty surprises: the link is weaker if we look only at economic upturns. And of course correlation is not causality. Some of the link is because some things are bad for both output and shares, such as tighter credit conditions or pandemics.
Nevertheless, there is a link from output to share prices. It’s not that equities get lots of earnings from manufacturing activity. They don’t: I’m using manufacturing output as an indicator of general cyclical conditions. Instead, it’s because of something pointed out by Harvard University’s Matthew Rabin and colleagues. They show that we are bad at predicting how our future tastes will change. For example, people pay too much for convertible cars and houses with swimming pools in the summer because they fail to see even the obvious fact that they will be useless in the winter. Rabin call this the projection bias: we project our current tastes into the future.
In the same way, investors fail to see that better economic times will increase their appetite for risk. In this way, even an upturn that everybody expects can cause share prices to rise.
Which is a reason for optimism, because the economy is likely to grow strongly in the next few months. The CBI recently reported that manufacturers' order books and output expectations have both risen. And economists now forecast that real GDP will grow by 6.4 per cent this year, its biggest expansion since 1973. Even if markets are pricing in the impact of this on earnings history suggests they are not pricing in its impact upon our appetite for risky assets.
If this is so, then we have a reason to expect equities to rise even further. If output returns to its pre-pandemic level by next spring, then post-1998 relationships point to equities rising around 7 per cent in real terms – which implies another 700 points on the FTSE 100.
But there’s a problem here. This strong positive correlation between output growth and equity returns has only existed since the mid-1990s. From 1971 to 1997 the correlation between the two was actually slightly negative.
And there’s a good reason why this should be. Yes, economic upturns raise earnings expectations and appetite for risk, thus raising share prices. But they can also increase fears of rising interest rates. Net, it’s not obvious why upturns should be so great for equities. And before the mid-1990s they were not.
What changed then? Simple. We never really saw big rises in rates during upturns – certainly not big enough to scare markets. This is partly because inflation has been low and stable (which it wasn’t before the 1990s) and partly because the forces of secular stagnation have reduced real interest rates over the last 25 years. Thanks to this, equities have enjoyed the benefits of economic upturns without the downsides.
And herein lies the danger. If the coming upturn sees a significant rise in interest rates – which would be most likely because of rising inflation – we might get a return to the pre-1990s pattern in which strong growth didn’t benefit equities.
Personally, I’m not at all sure we need worry here. Yes, inflation will rise. But most of this will be because of base effects (such as last year’s fall in oil prices and cut in VAT on hospitality dropping out of the numbers) and because of temporary mismatches between the patterns of supply and demand which will fade over time. Interest rates will therefore not have to rise very far.
Even if I am right, however, there’s still a risk. Stock markets are not always governed by the facts. It’s quite possible that investors will worry that others will worry about inflation and interest rates. This alone would hurt equities.
So, yes, the link between output growth and equities returns is a reason for optimism – but only for cautious optimism.
