Key Indicator – Stock Market behaviour predictable or not?

stock market predictionsAt the start of the new decade predicting stock market behaviour is anything but an easy task.

A year ago, the pundits variously predicted that the year-end valuation of the FTSE 100 would be anywhere between 7200 and 8400 points. In the end, at close of business on 31st December it was in the mid-7000s at 7542 below most predictions but it was still a stonking year.

Over the last year, stock market values, including the UK’s FTSE 100 and 250, have risen an astonishing amount to make 2019 one of the strongest years ever, despite a sluggish global and EU economy, US and China trade wars and Brexit uncertainty.

According to the business news two days ago the Dow Jones industrial average has seen  a rise of almost 25% having reached record highs day after day, the broader S&P500 is up 30% and the tech-heavy Nasdaq has grown 40% in value. The FTSE100 in London is also close to its record high, as is the Dax30 in Germany.

In so-called “normal” times the stock markets traditionally go down when the interest rates go up which may explain the stock market values given the unprecedented period of low interest rates set by Central Banks that have done everything they could to support their countries’ weakening economies in their attempt at stimulating growth or more accurately avoiding recession.

But what is “normal” given that some Central Banks including European Central Bank, Japan, Sweden, Denmark and Switzerland have set negative interest rates?

To make predictions more difficult, this has been going on now for more than 10 years, since the 2008 Financial Crisis, and growth/recovery is still pretty sluggish despite the stimulus.

Usually, over a 10-year period there is a natural economic cycle from “boom” to “bust”, but the “bust” has yet to come, and nor is it being predicted. More of the same seems to be the view of most economists.

However a few pundits, notably the economist Nouriel Roubini, Professor of Economics at New York University’s Stern School of Business, argue that the stock markets are far too optimistic, while the business writer Rana Foroohar, author of Don’t Be Evil: The Case Against Big Tech and associate editor at the Financial Times, predicts that the next crash will be brought about by the concentration of power in the hands of big tech companies like Apple, which have built up huge amounts of debt in their quest for power. She says: “Rapid growth in debt levels is historically the best predictor of a crisis.”

So, why have stock market valuations continued to climb?

In my view, two things have driven the value of companies listed on the stock market.

Firstly, businesses have broadly maintained their profitability by reducing overheads through slimming down management and not reinvesting. This has hidden their decline in productivity because profitability has been maintained. I believe that the cutting out of swathes of management has made many businesses extremely lean but left them without scope for responding to growth, with little experience for investing in new technology and for implementing the changes necessary to remain competitive.

Secondly, the numbers of listed companies have declined leaving fewer in which to invest money. Given that investors want to invest in profitable businesses this has meant that the pool of investable companies has also shrunk driving up the value of those that should be part of an investment portfolio. This distortion is likely to encourage a shift from the growth investment strategy preferred by long-term investors to one of value investment preferred by those with a higher appetite for risk. Indeed, picking winners is difficult as those who backed Neil Woodford will attest.

You could argue that UK based companies exporting abroad with foreign investors have benefited from exchange rates problems due to Brexit to make more locally focussed companies more attractive but this should only be part of a value investment strategy and still leaves the long-term investors looking for fundamentally sound businesses.

It’s possible that once Brexit is under way after January 31, there will be a re-rating because the companies that import from abroad have suffered disproportionately.

It will only take the Central Banks raising interest rates to more normal levels for a major stock market crash to become inevitable.

 

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