SUMMARY. This month we’re looking at bad behavior, confidence and market valuations. And why UK investors MUST pay attention to the US, albeit not the news headlines about the US.
The key points are:
- Investors anchor their analysis to one piece of news which is constantly talked about in the media – it is accessible, it is simple….
- But the reality is typically more complex, and less accessible, which is less appealing for investors
- Investors prefer an (ultimately) incorrect but simple solution to a complex, and unpalatable, but correct one
- UK investors must take a realistic view on where US equities are on the journey from cheap to expensive
- Even a fall of 40% would merely bring the US stock market back to the long term average valuation
Confidence is vital to markets and economies. That’s a simple truth, and judging prevailing confidence is vital for investors. But that judgment is difficult, and most investors don’t do “difficult”. Investors prefer an (ultimately) incorrect but simple solution to a complex but correct one.
Take the US (partial) shutdown. These have been quite regular through history (18 since 1976). None have had significant impact on equities. On this occasion the monthly cost of the shutdown pales in comparison to the size of the economy and monthly QE.
Yet analysts and the media focus on this alone as a reason to sell/buy the US stock market, and investors play along. This is one example of the many investor behavioural problems. Investors anchor their analysis to one piece of news which is constantly talked about in the media – it is accessible, it is simple. But the reality is more complex, less accessible, and therefore less appealing for investors. More complex analysis is ignored, particularly if it is counter to their prevailing view.
The level of confidence is difficult to judge, particularly because, as an investor, you can hardly be objective (because you are one of that crowd of investors whose confidence you are trying to measure!). For example, assume you have bought into the US stock market. Someone (unkindly) draws your attention to the market valuation based on cyclically adjusted earnings (CAPE). You choose to ignore this as it highlights that the US stock market is currently in the top 5% of the most expensive periods in history going back to the 19th century. And despite the fact that even a fall of 40% would merely bring the US stock market back to the long term average valuation.
The drivers of confidence can also be difficult to pin down. Ben Bernanke is (was?) convinced that using QE (printing money) to drive the stock market higher will trigger a wealth effect, and the 1% who become a lot richer will somehow spur the wider economy. If Bernanke is right, imagine how bad the weakest recovery of all time would have been if the US stock market hadn’t more than doubled in the last 6 years!
Nonetheless we have sympathy with those who say that confidence is all that matters. The richer people feel, the more they spend. The more confident are CEOs about a rosy future, the more likely they are to approve capital expenditure and more hiring. This is how growing confidence underpins an economic recovery which becomes self-reinforcing and self-fulfilling.
As with the economy, so does stock market confidence also have a clear path. A bull market is defined by a journey from no confidence and cheap valuations (the essential ingredient for a bull market to begin) to expensive (when that confidence about the future morphs into certainty and complacency).
Whether you like it or not, and whether or not you would ever invest in the US market, as a UK stock market investor you must pay attention. The correlation is very high between the US and UK market, in fact between the US stock market and most others around the world. So if the US tumbles, so does (almost) everyone else.
Therefore as an investor in the UK stock market you must take a realistic view on where US equities are on the journey from cheap to expensive, and plan your UK investing strategy accordingly.