Market behaviour

How will markets perform over the next twelve months?

The simple answer to the question is this; not smoothly. We had already witnessed what was the least volatile market in a century back in 2005 which is unlikely to be repeated in 2008. Stock markets are characterised by four-year cycles that have been in place since 1934. Such periodicity may well be related to the US presidential terms of office but the fact it exists at all is more interesting than the cause, as it would appear contrary to academic logic. Then again those who believe that markets cannot be beaten are frequently academics with little hands-on experience.

The rule of thumb is that stock markets undergo a significant sell-off every 4 years and by that we mean losses of at least 15%, from peak to trough. The last time we were supposed to encounter such a (healthy) clear-out was in 2006. Instead it appears that the stock market is on an unstoppable upward course, taking credit crises and turmoil gleefully in its stride. While rising share prices make for an easy life when dealing with clients, we should always remind ourselves that the forces of mean reversion will pull markets back like an overstretched elastic band; or they will snap completely. The last time we missed a 4-year hit was in 1986 which was of course followed by the ’87 crash. With markets on a similar parabolic rise (vertically up the chart) it would make sense to prepare for the worst in 2008, assuming markets have not already been mauled by the time this article is published.

While it is tempting to batten down the hatches and make a dash for cash one should not forget that the final phase of the bull market can also be the most spectacular and therefore the most profitable. At such times euphemistic language abounds and new paradigms are the watchword - it will be interesting to see what the next buzzword will be. For those with a few scars and even more grey hairs, such talk will itself be an indicator that an exit strategy must be prepared. This euphoria is of course an outward demonstration of a trio of human failings: assumption, extrapolation and the fear of missing out. Every bubble down the ages has exhibited similar traits where credit is the fuel for a feverish accumulation of whatever is in vogue. While the object of our desire may vary, the behaviour remains the same. The trick of the trade is to ensure that one is not left holding an over-inflated asset as the greater and final fool in a string of speculators. It is fascinating to see how selling volumes reach a climax as the price of bubble items peak. This is known as the distribution phase where smart insiders and institutions ditch their investments onto a gullible public – not that the former would refer to their clients in that way. After all, the marketing literature of banks says that the clients’ interests come first, so it must be true.

One of the most compelling arguments for a large advance comes from looking at performance charts. At its intra-day peak in March 2000, America’s most important stock market index (the S&P 500) rose to a record of 1553 as the technology bubble reached its zenith. In July 2007 the index again hit exactly this level and promptly fell by 12% - a big figure indeed, but not enough to satisfy the 4-year rule. This was a very bad sign which some interpreted as a negative ‘double top’ formation. By October 2007 the market had rallied aggressively and the old high point was breached: the stage is now set for a make or break move in equities. When share prices break their previous peak then this is taken as a buying signal by professionals and is not a cue to take profits.

While charts may help with timing, it is ultimately the fundamentals that determine market direction. One of the most influential factors in driving up shares in America has been the investing behaviour of the so-called baby-boomers. The surge in the birth rate after the War has led to a generation of productive workers saving for their pension directly or indirectly via the stock market. 2008 is a crucial year when that population bulge turns from being net investors to net sellers of equities as they hit retirement. A similar phenomenon occurred in Japan in 1989 as their property and stock market bubbled and burst. Anyone around at the time will remember the text books proclaiming the Japanese miracle – the economy has been stagnating ever since. To avoid the threat of an era of Japanese-style deflation the American government and central bank (theoretically independent of each other) are acting in unison to pump up the economy artificially. This is achieved by issuing ever-greater volumes of government bonds to subsidise low taxes while suppressing interest rates to protect the housing market. The great paradox is that while they talk tough on inflation such actions are the direct cause of its resurrection. It is no wonder that gold is surging and the dollar slumps as foreign central banks grow weary of accumulating such a diluted currency. If the path to prosperity comes from printing paper then 2008 will be no doubt be a bumper year; but it will be the first time in history that the mass-production of money has not lead to serious inflation and eventual economic chaos. Happy New Year!

Toby Birch
October 2007