Financial markets and the real economy march to a different beat. The UK stock market fell rapidly between January and June this year as inflation and rising interest rates moved front of mind, but there had been straws in the wind for months prior to that. The multiple of earnings that investors were prepared to pay for shares had been drifting since the spring of 2021.
Markets are discounting mechanisms. They are not really interested in what is happening today, preferring to focus on what they think will happen tomorrow. That’s why shares were getting cheaper for nearly a year before the penny dropped that the Federal Reserve (Fed) was serious about fighting inflation. As James Goldsmith put it: ‘by the time you see a bandwagon, it’s too late’.
John Maynard Keynes, the economist, used to think of stock market investing in terms of a newspaper beauty contest game. To play, contestants had to pick six faces out of a hundred. The winner was the one who identified the six most popular choices. It was an upside-down version of the TV game show Pointless.
The naïve strategy for a player of Keynes’s game was to pick the six faces they thought most attractive. More sophisticated players would think about the features that most people would be drawn to. The canniest contestants would try to anticipate ‘what average opinion expects the average opinion to be’ as Keynes wrote in his General Theory.
Keynes thought that stock markets worked in the same way, with successful investors not simply identifying the investments that were fundamentally attractive but the ones that they thought most other investors considered good value. Or indeed that most investors thought that most other investors would like. And so on.
This approach works when it comes to which investments to buy, but it is also relevant when deciding when to buy them. A year ago, it was not just a matter of anticipating the Fed’s tightening cycle but also worrying about higher interest rates before other investors got there.
More recently, investors have jumped even further ahead and started to think about what happens once the Fed stops hiking and starts re-stimulating a slowing economy sometime next year. This may be why market timing is so difficult and why it is easy to be just a little bit behind the curve when it comes to market turning points. You should think several moves ahead to stand a chance.
The challenge facing investors is even more complicated than this because it’s not just the lag between markets and the economy that matters. Also important is the variable linkage between different asset classes and what’s happening in the real world.
Shares are typically the first to move. Investors know that when it comes to earnings, the announcement of results is the end of the process. Share prices have factored in higher or lower profits long before earnings season arrives. Indeed, poor results can sometimes trigger a share price rally, if they are not quite as bad as feared.
Government bonds are also quick to pick up on changes in the macro environment. The yield on US Treasury bonds, for example, was above 3pc long before interest rates had got close to that level. Now that interest rates are catching up with bonds, yields are heading the other way in anticipation of next year’s likely recession. The moment to lock in 3.5pc on a 10-year Treasury was fleetingly brief.
Corporate bonds tend to lag behind government debt because, even as interest rates and Treasury yields are rising in response to rising inflation, investors may still be keen to buy corporate bonds against a buoyant economic backdrop. It’s only later, when the threat of recession feels more real, that investors start to demand more compensation for the higher risks of lending to companies than governments. That process has now begun and the gap between government and corporate bond yields is widening.
Next in line are late cycle assets like commodities. At the beginning of this year energy and industrial metals prices were riding high. And, as recently seen, the long-term case for natural resources remains strong. But the cycle is now against the likes of copper, down 15pc year to date, as investors worry that short term demand will fall as the economy slows.
The riskiest parts of the market at the moment, the next shoes to drop, feel like the illiquid assets where prices may not move until after the changes have shown up in the real economy. Commercial property is the most obvious case in point. A lack of buyers, and sellers refusing to face up to reality, mean there are not enough actual deals to validate today’s valuations. The UK property prices appear to be holding up but if you really want to see what’s going on, look at the quoted market for real estate investment trusts (REITs). Prices have fallen to yawning discounts to stated net asset value, which tells you all you need to know about what’s likely to happen next in the physical market.
The same absence of transactions means private equity markets may be the last to price in changing conditions. An unwillingness to raise money or come to market at depressed values can leave investors with a false sense of security about the real value of their unquoted investments.
And then it all begins again. Just as equity and bond investors were the first to pull the plug, it will likely be stock and Treasury markets that regain their mojo first. You may have missed one bandwagon, but I believe that another will be along shortly.
