21 December 2017
2018: A Bull Market – For Complacency.
A herd mentality with lazy thinking is a dangerous recipe
By Frank O’Nomics
It’s that time of the year when economists and analysts come up with their predictions for growth, inflation and the best performing asset classes for next year. The almost universal positive outlook might reassure you – even the UK is expected to show growth of 1-1.5% next year – with the Goldilocks’ scenario of steady growth and low inflation forecast to continue to push equity indices to fresh highs. There is some logic to this, with most of the pitfalls of 2017 having been successfully negotiated – particularly those of a political nature. However, the positive outlook for returns wilfully ignores the extent to which markets have already priced in the best possible scenario – the US equity market, for example, hit its 70th fresh high of the year this week. In an environment of ultra-low interest rates, the income being generated by most assets classes is very modest and would become irrelevant on even a small correction in prices. Why then is everyone so bullish?
There seem to be two instincts that drive the generation of forecasts. While most analysts at top institutions are exceptionally well qualified and research meticulously, there is a reluctance to take risks. First, there is a strong tendency to assume that, whatever the recent trend it is likely to continue. Given that we are in a bull market, and that it has been correct to assume its continuance for each of the last 9 years, it is not surprising that most analysts err on the side of yet another positive year. This is regardless of a wide range of calculations that point to equity and bond markets being overvalued as we discussed two weeks ago. Companies that employ analysts generally make more money when they find fresh investment so, if in doubt, be positive. The second instinct is not to be an outlier. If your models point to an outcome that is more than 1-2 standard deviations from the consensus, you are putting yourself in the dangerous position of being the worst forecaster of the year – much better for your career prospects to moderate your investment call based on what the herd is suggesting.
To illustrate the point take a look at the range of New Year forecasts that will feature in numerous articles appearing over the next 10 days. I recently attended a presentation by a senior strategist at a large bank, who had been flown in to London specially to give their 2018 outlook. The rosy economic view was well argued on the basis of impending Trump tax cuts and a moderation in the danger of a credit bubble in China, with a global growth forecast that sits comfortably within the consensus at 3.8%. Particularly strong cases were made for European, Japanese and emerging market equities. However, when it came to illustrating this in chart form, they could not escape the fact that all of the areas covered (except Japan) had price-earnings ratios that sat at the top of their 1yr trading range, and that this range was (again excepting Japan) comfortably above the average for the last 12 years. What the charts seemed to be pointing to is a market that prices in a very positive scenario already, and not one that was getting ready for the withdrawal of global liquidity that will come with the end of quantitative easing. The other area of concern was the fact that around half of the total returns that they were forecasting were to be generated by dividend income. It will only take a modest reduction in capital values to negate the benefit of those dividends.
While still sitting within the consensus, most analysts employ some scenario analysis as a pre-emptive way of explaining why they got things wrong. This year the spectre of inflation gets a passing mention from many, at least for US forecasts and, while most feel that the danger may have passed, the Chinese credit bubble remains a worry. Where analysts are less comfortable is in factoring in the possibility of geopolitical disruption. The skills of an analyst, used to building economic models and forecasting corporate earnings, do not usually extend to allocating risk probabilities to a negative events emanating from Korea, Russia or the Middle East. 10-15 years ago some banks took the trouble to hire geopolitical analysts (often from the CIA), but they are now a luxury that few can justify, given that they are unlikely to generate specific trade recommendations.
It would be wrong to be overly cynical. It may well be that the consensus will be proved right with those fully invested ending 2018 comfortably richer. Further, there are analysts, and importantly some key fund managers, who are prepared to stick their necks out and argue against the trend and the consensus. Here again we have to be a little careful, as there are those who want to generate headlines and hence some notoriety with dramatic tales of impending doom. As for the majority perpetuating the positive outlook, there are potentially two significant consequences. First, those who commit themselves to growth related assets could see even small disappointments in economic data or corporate earnings prompt a very sharp correction in prices, which will more than offset any income generation. The second is for the analysts themselves. I have spent a great deal of time recently asking fund managers how much they are expecting to pay for research on the introduction of MiFID 2 regulations. Many have yet to make a decision, some do not want to pay anything and may try to do much more in house, while a significant number will have a restricted budget, which will mean cutting back on the number of analysts that they subscribe to. The analysts most likely to see declines in subscriptions are the “me too” brigade – and current forecasts suggests that will be a great many.
