Secrets Of Success: That yield curve - am I bothered?

My friend Ken Fisher, the American money manager, likes to point out that the one thing that will not spook markets in the year ahead is the one currently being most talked about in the media and markets.

This certainly proved the case with Y2K back at the end of the 1990s; with the rise in oil prices 12 months ago; and with the great deflation worry shortly before that. Was it only a year ago that everyone was worrying about the further fall in the value of the dollar?

Well, of course that hasn't happened. The world economy and stock markets have (so far) managed to live quite comfortably with the dramatic rise in oil prices we have seen in the past year, not to mention the continued migration of many long-term institutional investors (such as pension funds) out of equities into bonds. That hasn't stopped the stock markets recording another strong showing in the past year.

The reason for this apparent paradox is the standard one that if everyone is worrying about some specific future problem, it means that the outcome is by definition already priced into the market - there is nobody out there who hasn't already acted on it.

So, normally, one could be fairly certain that the big worry of the Christmas period, which was the inversion of the yield curve in the United States, is probably not going to be a threat to investors' returns this year.

The shape of the yield curve is actually one of those maddening indicators that are usually - but not always - important. When short-term interest rates rise above longer-term rates, it is more often than not a sign that difficult economic times lie ahead; sometimes a recession, sometimes something worse. Alas, the indicator does not tell us much about how quickly that is going to happen, and sometimes turns out to be a false alarm.

The reasons why an inverted yield curve is a worry are not hard to find. Typically, it means that the central bank is raising short-term interest rates to cool the economy while longer-term growth and inflation expectations are low. It is a critical step in the credit cycle. An inverted yield curve means that banks have less incentive to lend money. Tighter credit is one mechanism that brings an economy that is expanding too fast back into balance.

On this occasion, market optimists take comfort from the fact that the current phase of interest-rate tightening by the Federal Reserve just unwinds the unprecedented period of easy money that preceded it.

It is not the punitive measures of days gone by, when the central bank felt obliged to head off a resurgence of inflation in an overheated economy by putting the brakes on through monetary policy. In real terms (after inflation), short-term interest rates are still not at punitive levels.

As to the timing of any impact on investors, I am indebted to Richard Bernstein, Merrill Lynch's US quantitative strategist, for the data shown in the table. This shows you how much predictive value there is in various indicators.

More precisely, the figures show the r-squared (or statistical correlation) between the indicators and the 12-month forward value of the S&P 500 index. The data are based on experience over the past 20 years. The nearer the number is to 1.0, the greater the correlation; the nearer to 0.0, the less power it has.

As you can see, most of the indicators have virtually no predictive value for the year ahead, and the yield curve (as measured by the gap between three-month and 10-year government bond yields), has the worst rating of all.

What this really tells us is what we all know already; that making predictions about markets a year ahead is pretty much a complete waste of time. For the record, the sell side indicator that scores best in Bernstein's table is a measure of how bullish professional forecasters are - the more bullish they are, the more confident you can be that stocks will not do well. At the moment, it is at a high level by historical standards, though not as high as it was five years ago.

In the case of the yield curve, there is the complication that stock markets are traditionally leading indicators - they typically turn down before the economy does, with a lag of several months. So you might just as reasonably conclude that the fact that the stock market is still riding high at the point that the yield curve has only just flattened out (it has not really inverted yet) implies that no downturn is likely until the end of this year at the earliest.

As I noted a few weeks ago, there are several good reasons for being wary of a market correction in the coming 12 months, and you should be prepared for one. The shape of the yield curve is one of the indicators that needs watching. Even so, a trend is a trend until it ends and the factors that have driven the market this high so far - strong corporate balance sheets, high earnings and attractions relative to bonds - are still pretty much in place.

They could yet carry the markets higher into the second quarter of the year. In particular, the Japanese market, an old favourite of this column, is now obviously a little overbought in the short term, but remains an attractive medium-term bet. The market is highly geared to a revival in inflation, property prices and interest rates, all of which now seem to be happening (though from the perspective of my personal portfolio, it is a pity it didn't start happening three years ago).

Meanwhile, Anthony Bolton, Fidelity's master stockpicker, said just before Christmas that the current bull market is probably now close to its peak. It has already lasted longer than most post-war bull markets and is beginning to feel rather tired. I agree, but the final stages of any bull market often provide the most impressive gains before the trend expires. Enjoy it while it lasts.