The perils of insouciance
Jonathan Davis says investors’ disregard for risk has paid off handsomely in 2006 — but it may not in 2007 Agood general rule for investors is to take no notice of consensus predictions about what is going to happen in the next 12 months. The track record of year-end investment punditry is consistently poor. That makes the Christmas and New Year period particularly hazardous for the unwary investor, as the demand for forecasts is at its peak, and the capacity for misdirection consequently also high.
This is especially so for those who are not aware of J.K. Galbraith’s adage that economists forecast ‘not because they know, but because they are asked’. One professional investor of my acquaintance has turned forecasting folly into a source of insight. Ken Fisher, an investment manager from the West Coast of the United States, logs the market and interest-rate predictions of all the mainstream market forecasters in the US, who are legion. His own forecast is then based on the simple premise that the actual out-turn in any given year, whether for interest rates or stock markets, will not fall into any of the bands that more than one expert expects. So far his results have been remarkably successful. Most of the time, he finds, most forecasters cannot even get the direction of the stock market right, let alone the scale of the change.
As the City’s pontificators are still working on their predictions for 2007, it’s too early to tell in which wrong direction this year’s endof-year consensus will go, but looking back on the investment story of 2006 will make pleasant reading for most investors. Despite dire warnings about the likely impact of higher interest rates and the collapse of US house prices, 2006 looks like ending as a year in which insouciance, or disregard for risk, has again paid off handsomely.
Despite a minor panic attack in financial markets between May and July, most types of assets will make positive returns this year. The US Fed’s decision in August to call a halt to two years of successive interest-rate increases helped to re-energise most markets after the mid-year setback. The continuing availability of cheap credit has again helped to push a wide range of asset prices higher.
Record auction-house prices for Old Masters and vintage wines, crazy happenings in the top end of the London housing market, Iraqi government bonds selling on a 9 per cent yield and booming mergers and acquisitions activity around the globe — all ultimately lead back to the easy-money conditions that have helped push so-called risk premia (the margin that investors allow for things to go wrong) near to all-time lows. Not for many years, in fact, have so many financial assets been priced for perfection — that is to say, on the assumption that good times will roll on. Warnings by the Bank of England and other central bankers of unsustainable returns on some of the more buoyant asset classes such as housing and private equity — have fallen on cloth ears.
This year’s market indicators therefore paint what may be a misleadingly comforting picture. Commercial property has again led the way in 2006 with a total return of nearly 20 per cent. While bond prices have mostly been flat or falling, stock markets in general have had a good year, with the MSCI world index showing a total dollar return of 19 per cent and the FTSE All-Share index a return of some 12 per cent.
In terms of individual markets, the story has not been quite so straightforward. Twelve months ago the stock market most widely tipped to do best in 2006 was Japan. Yet in practice the Tokyo stock market has had a poor year, lagging most others, except those in the Middle East, where a flood of speculative activity fuelled by soaring oil revenues produced a dramatic market bust. Emerging markets have again outperformed most developed markets, with Russia, arguably the riskiest of all, in the vanguard. In the UK the middle section of the stock market, where most of the M&A activity is concentrated, has led the way, although there are signs in recent weeks that a long-expected rotation towards larger company shares has also finally begun.
Hedge funds, meanwhile, the faddiest of today’s fads, have mostly had an indifferent year, with average returns barely superior to those on offer from a decent bank account. Too much money flooding into the sector, combined with high fees charged by managers, have had a dampening effect on returns.
Oil prices are currently little higher than they were at the start of the year, despite predictions then that they were on their way to $100 a barrel, while many other commodity prices have gone higher over the past 12 months, notwithstanding a sharp sell-off in mid-year. Gold is up 22 per cent and silver 54 per cent. The warning signs here are that many commodities are now selling above their long-term replacement cost, while the normal ratio of current to future prices has reversed. In normal times both these developments would be regarded as clear danger signals, but in today’s happygo-lucky markets investors brush such considerations aside. In the currency markets, the big story of the year has been the accelerating fall in the dollar, against the pound in particular. This is one trend that was widely predicted a year ago — although it had also been predicted even more universally the year before, when it notably failed to happen.
In the short term, it is by no means impossible that the good times will continue. The third year of a US presidential term is normally positive for stock markets, the M&A boom will continue as long as cheap credit is available, and the history of bull markets is that they tend to run on longer than hardened market veterans ever imagine to be possible. The more good years there are, the more relaxed investors tend to become about the risks they cannot see. While most pundits expect a moderate slowdown in economic growth in 2007, leading to lower bond yields and creating a headwind for stock markets to push against, there is no guarantee that it will turn out that way.
But history has its own way of taking revenge on insouciance. The risks in today’s asset prices are no less real for being put to one side. If investors look three to five years ahead, rather than to the fog of uncertainty that is 12 months ahead, future returns become more predictable. The sectors and markets that have done best in the past five years rarely sustain that relative performance over the next five years.
That is why prudent investors with a longerterm horizon are already starting to turn their attention towards the shares of larger rather than smaller companies. Technology and telecom stocks will do better over three years than commodities and property. The one prediction you can make this year with confidence is that risk will once more have its day.
Jonathan Davis edits Independent Investor.
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