When markets are as choppy as they have been in the past week or so, it is easy to take our eye off the horizon. We focus on the short-term noise even though, in the long run, it makes no difference whatsoever to our wealth, health and happiness. It is far simpler to tell ourselves to focus on our financial goals than to actually do it.
This week, therefore, I’m going to step back and look at what has happened over the past five years and outline three possible scenarios for the next five. Without a crystal ball, we don’t know which of these will actually come to pass but we can assign probabilities and by doing so make more measured decisions than we are likely to do while transfixed by the rolling news headlines.
The past five years have been good to investors. We’ve been in a bull market, albeit with some worrying corrections like the one we experienced last autumn. You could argue that we have been in a bull market since 2009, when shares stopped falling after the 2008 credit crunch. It might be more useful, though, to see 2012 as the start of the bull run as this was the point when the US stock market finally exceeded its dot.com peak in 2000.
This feels like a better starting point for two reasons. First, because in the 12 years between those dates, investors were simply playing catch up. They received dividends but enjoyed no overall capital growth, assuming they were invested at the outset. Second, focusing on 2012 as the start of the bull run makes it seem less long in the tooth. It’s easy to think that the market must be due a downturn just because it’s been going on for such a long while. The length of time since the last bear market is, however, irrelevant.
There are two reasons why shares performed so badly between 2000 and 2012 and relatively well in the years since. Corporate earnings suffered two big falls following the dot.com bust and financial crisis whereas the past seven years or so have seen much more benign conditions for companies, helped by lower interest rates and a nervous, and so compliant, workforce. The other key determinant of share prices, valuation, underwent a long downward adjustment prior to 2012 and has since broadly remained steady.
Going forward, these two factors will continue to shape the outlook for markets. How quickly, if at all, company profits grow from here and the price investors are prepared to pay for those earnings will be the keys to which of three possible scenarios unfold over the next five years.
Looking at valuations first, this is actually not a bad starting point. There are some areas of over-optimism, largely in the tech sector and where investors see disruptive companies eating the lunch of less nimble incumbents. The prices being paid for the perceived safety of lower-risk, defensive businesses are also in some cases probably too high.
But, generally speaking, valuations are no higher than they were five years ago. Stock market gains have been fuelled by growing profits not higher multiples. The euphoria which usually marks the end of a bull market is notable for its absence.
So, the most important driver of markets in the years ahead is likely to be the direction of earnings. Over any longer period, profits are the most important determinant of stock market returns. And that is why the most important question right now is whether we are heading towards a recession.
Clearly, the increase in trade tensions is unhelpful in this regard and it is not irrational for investors to be reactive to the twists and turns of the tariffs drama. But the causes of most recessions in the past are not obviously present. Healthy profit margins do not suggest that companies have over-invested in capacity. And the banking system, cause of the last downturn, looks to be in much better shape than it was in 2007. The banks have rebuilt their capital buffers and got rid of the riskiest assets on their balance sheets.
The bond market is signalling that a recession is on its way but there are good reasons to think that ten years of emergency stimulus has distorted the yield curve’s message to the market. It’s been a reliable indicator of downturns in the past, and I’m loath to say that it might be different this time, but maybe it is. I would put a 20% probability against scenario 1: recession.
The second possible outcome is also not the base case, albeit probably a bit more likely than the first. I would say there is a 30% chance that renewed monetary stimulus from the world’s main central banks and increased spending by nervous and increasingly populist governments will see some of the money that has exited the stock market in favour of bonds and cash come back again. Higher profits and rising valuations could see the bull market continue to climb the wall of worry that it has scaled for the past seven years.
Which leaves a 50% weighting for the third and most likely scenario. This will see a long period of low global growth, held back by increasingly protectionist, anti-globalisation tendencies in all the world’s key markets. In this environment, company profits can still rise but it will be harder work than it has been, especially if the balance between labour and capital shifts back towards workers and away from owners. Valuations will probably remain at or around their current levels.
What do I take away from this exercise? That markets will be subject to periodic bouts of volatility; that investors will continue to pay a premium for quality; and that the anxiety which has seen $25bn taken out of equity funds and $100bn put into cash in the past week will be unwarranted.
More on opportunity in uncertain times
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