Secrets Of Success: My advice on the markets? Be wary

If the stock markets are due for a significant correction, which we will discover in the next few weeks (and seems probable to me), what does it tell us about the way that markets operate?

The paradox is that the case for being bullish remains, on the face of it, so strong. The world economy has been growing strongly, company profits are at high or even record levels in some cases, and share-price multiples are not high by historical standards. Earnings yields are some way above comparable bond yields.

The case seems so good that it has made the life of stockbrokers, whose primary job is to sell shares, all too easy. The revival of flows into equity funds points to the same thing happening in the funds market.

The catch, of course, is that this is just not the way markets work, at least short-term. In the short term, the price of securities is driven primarily by liquidity and investor sentiment, not by so-called fundamentals.

The fundamentals of earnings, cash flow and dividends can and do change in response to the economic cycle and competitive pressures, but they never change anything like as fast as the way investors in aggregate choose to value them. If fundamentals were all that mattered, the stock market would not move in anything like the jagged, volatile fashion it does.

In part, the volatility of share prices has something to do with investors' attitudes to risk. If you feel confident about your finances and the world outlook, you may be more prepared to take risks with your money. You will find yourself, for example, investing in emerging markets rather than boring old blue-chips.

When something happens that worries you, or if your circumstances change, it is natural that you will look to draw in your horns a bit. Magnify that reaction many millions of times and you have one of the dynamics that drives current prices in global stock markets.

The price you see on the screen is the marginal price of a share, the one at which a few active buyers and sellers are willing to trade. It is not the same as the share's intrinsic value, or the price that would prevail if everyone who owns it opted to buy or sell at the same time.

A secondary factor is that share prices are not set in isolation. The new money that investors direct into stock markets can also potentially go into other types of financial asset. A hundred years ago, the main alternative was government bonds, but today the list of competing asset classes has proliferated hugely. Technology means that we can switch our money in minutes from one side of the world to another.

We can do the same with investments: even life companies, the dinosaurs of the investment world, now offer clients the chance to switch holdings from, say, UK property into Japanese equities at the click of a mouse.

What this means, of course, is that share prices are also influenced by the current attractiveness of competing assets. Interest rates are a key factor in this. If the amount you can earn on your bank account rises from 2 per cent to 5 per cent a year, it should make you think harder about the wisdom of investing money in shares, which offer higher returns than cash (but at the price of higher risk).

It makes little sense to put £5,000 into a long-term bond that yields 5 per cent if you can earn the same return risk-free by keeping it in the bank.

Finally, behavioural habits, or herd instincts, are a big factor in how financial markets operate in the short term. What we do with our money is heavily influenced by what other people are doing. The stock market, as Keynes observed, is a bit like a beauty contest in which the secret of success is not to pick the most beautiful contestant, but to try to guess which contestant everyone else will think is the most beautiful.

The managers of most actively-managed funds are engaged in this game, which is why their turnover levels are so high and average long-term results so indifferent. It takes a strong character to ignore what others are doing and go against the crowd.

By disseminating so much information about how the market is moving, the media help markets to operate but at the same time unwittingly add to the short-term herding phenomenon.

Throw all these considerations together, and it becomes easier to explain why stock markets today are vulnerable to a correction. The fundamental picture is undoubtedly still good.

As Ian McVeigh, manager of the Jupiter UK Growth Fund points out, UK company earnings have grown by 50 per cent since the market peak in 2000, yet over the same period, forward price-earnings ratios have fallen from 23 times to 14 times. Company balance sheets are also, in aggregate, in good shape. Economic growth is healthy in most leading economies.

On the other side of the equation, global liquidity (the surplus money looking for a decent return) is no longer growing as fast as it was, with central banks in many countries tightening policy in anticipation of renewed inflation. Higher interest rates threaten to make other assets appear more attractive than shares. And, while price-earnings ratios appear cheap by recent standards, the fact is that they have been trending down steadily for several years.

One reason is that unless capitalism has completely lost its oomph, both theory and practice point to the current high level of earnings being unsustainable.

And behind all this lies the question of what will happen to investor sentiment and risk tolerance. By its nature, this can never be predicted for certain. But after three good years, suffice it to say that many of the conditions typically associated with turning points on these measures seem to be in place.

That is why, I suggest, wariness should be the order of the day for a while, despite the plausibility of many of the fundamental arguments being used to justify further stock-market advances.

jd@independent-investor.com