Secrets Of Success: Prepare for volatile market in 2006

Wise heads are starting to worry about the outlook for the stock market in 2006 and, having been positive for the last three years, when many market-watchers were not, it seems that this time the note of caution might be justified. There are a number of plausible reasons why some sort of correction might be in order next year, because, for one, it is not in the nature of stock markets to go up or down in continuous straight lines.

In fact, as Professor Robert Shiller and others have pointed out, historical experience indicates that the markets are far more volatile than the underlying trends in profits and economic activity, on which they ultimately depend, can possibly justify.

At the moment, the most striking feature of the global financial system is how little volatility there is by historical standards. Step back far enough and in hindsight the charts make it look as if the stock markets have gone up in a pretty continuous straight line since the lows of the bear market were touched in March 2003 (six months earlier in the US). Coupled with low interest rates, the absence of volatility has encouraged (or perhaps forced) investors to embrace risky assets with more than customary abandon.

It is a simple visual observation that the longer back in time you look, the less significant even big, scary events, such as the October 1987 market crash, appear. Months such as October, which saw some hefty corrections, are a useful reminder that this is not a blanket state of affairs. But the fact remains that on a global scale, investors are willingly taking on more risk today across a range of asset classes than traditionally they have been happy with.

In his latest quarterly letter to clients, for example, Jeremy Grantham, the founder of the US quantitative-based fund management firm Grantham Mayo Van Otterloo, which has data on every conceivable market trend you can imagine, says bluntly that many risk measures have reached all-time record lows. He thinks that this has resulted in "probably the lowest-risk premium on average recorded in modern times".

The kind of measures he is talking about are the spread between the yields on emerging market debt and US Treasury bonds (now very low), the similar story with junk bonds and AAA corporate debt (also very low) and the near-unprecedented discount at which "quality stocks" are valued by investors. Quality in this regard is a reference to companies with strong balance sheets, high returns on capital and stable profitability, for which you would normally expect to pay a premium.

Grantham also quotes the soon-to-depart chairman of the Federal Reserve, Alan Greenspan, who issued this apt warning during the summer: "History cautions that extended periods of low concern about credit risk have been invariably followed by reversal, with an attendant fall in the prices of risky assets."

Greenspan, in Grant-ham's opinion, and that of many others, deserves the "chutzpah of the year" award for this remark, given the central role the Fed's low-interest rate policy has played in encouraging the flight to risky assets.

One reason for the current state of affairs, Grantham also suggests, is a behavioural one. At any point in time, investors as a group are prone to extrapolate forward the continuation of current market conditions, even to the point of recklessness, as may be happening now.

Also a cause for concern, in his view, is the potentially destabilising activity of the hedge fund industry, which has $1 trillion of funds under management, which it leverages several times over in the pursuit of short-term returns.

If the markets do turn down, as they will do at some point, quite probably in 2006, this could create a worrying downward spiral. (The alternative perspective on the hedge fund point is that, because hedge funds as a class are prepared to accept risks that the majority of investors do not understand, their primary impact is to reduce, not increase, the level of overall risk in the financial system by adding new sources of diversification - an idea that has yet to be fully tested.)

Other analysts also see the scope for a downturn in the technical behaviour of the markets. Robin Griffiths, the head of asset allocation at Rathbones, says that 2006 looks like being "a tougher year", with a probable correction in most equity markets, matched by higher bond yields.

David Fuller, another seasoned market observer, who has called the current three-year recovery in equity markets, including the strength of resources, mining and emerging markets with impressive accuracy, also now detects some familiar trend-ending signs in a number of markets following their strong recent performance. He thinks 2006 will see a significant correction, probably led by Wall Street.

Of course, any sign that this kind of view is developing into a broad market consensus may well suggest that next year might, once again, surprise us on the upside. The year-end calculations of mainstream forecasters will give us some clue as to whether we need to lay off in a contrarian direction. But what cannot be denied is that the risk premium investors are currently prepared to accept for riskier assets is very low by historical standards. It means that markets are now somewhat "priced for perfection" and the greater short-term risk is clearly disappointment rather than further gains.

Timing the turning points in markets can never be a precise art, and attempting to outguess the rest of the investment community is a risky and potentially costly business. But investors, I would suggest, should be on the lookout for a significant correction, and prepare accordingly. The important thing is not to be caught out, or panicked, by the next cyclical downward move. The good news is it will create opportunities to buy into the major trends of the moment, such as commodities/resources and selected emerging markets, as the long-term outlook on those fronts continues to look promising.

jd@intelligent-investor.co.uk