Such thinking is dangerous. It’s an example of the limited attention effect. Most people, quite reasonably, don’t pay much attention to the stock market and so only notice it if it grabs their attention by moving a long way. The problem is, though, that by the time the market has risen enough to get ordinary people talking about it, it might well have risen too much. Joe Kennedy, father of JFK, realised this when he said that it’s time to sell when shoe-shine boys are giving share tips.
So, has the market risen too much? This question usually invites pundits to give us their “expert judgment.” But we don’t need such waffle. Economic research has found that there are several leading indicators of returns. Among them are:
The yield curve The idea here is that when long-term bonds yield more than short-term ones, it is a sign that economic activity is about to pick up, and such growth is usually good for shares. Right now, ten year US Treasury bonds yield 1.6 percentage points more than two year ones, implying that the yield curve is steeper than its long-term (post-1980) average. This points to shares rising.
Valuations When share prices are low relative to earnings or dividends, it often points to good returns. This needn’t be because markets are irrational; it might simply be that low prices are a sign that investors reasonably regard shares as unusually risky, and so require high expected returns as reward for holding them. In many western markets now, prices are low relative to earnings but not relative to dividends. What’s more, low price-earnings ratios might be a sign that earnings won’t grow very much in future. So this is ambiguous.
Volatility Common sense says that low risk means low return. A good measure of perceived risk is the VIX index, a measure of the implied volatility of S&P 500 options. Right now, this is unusually low. This means either that the trade-off between risk and subsequent returns has improved a lot, or that investors are being a little too complacent and so returns in the next few weeks will be modest.
Investor sentiment Jeffrey Wurgler of Stern School of Business and Malcolm Baker of Harvard have shown that investors’ mood swings predict returns. “When sentiment is high, subsequent market returns are low” they write. This is because sentiment mean-reverts; when we are pessimistic we subsequently cheer up and when we’re optimistic, reality later wakes us up. Baker and Wurgler use a range of indictors to measure sentiment. Two of them – relatively low turnover in US shares and low numbers of new issues – suggest investors have recently been pessimistic. And this points to good returns on US shares, especially the more speculative ones.
Capital flows It’s not just US investors’ sentiment that gives us lead indicators of returns. So does the sentiment of international investors, as measured by foreigners’ buying of US equities, reported monthly by the US Treasury. When such buying is high over a 12-month period, subsequent annual returns tend to be low. This is because high buying can be a sign of excessive exuberance. In the 12 months to November, foreigners bought $65.2bn of US equities, slightly less than the post-1996 average. This points to slightly above-average returns in the next 12 months.
Consumer spending It’s not just investors’ behaviour that can predict returns. So too can US consumers’. The idea here was pointed out back in a classic paper back in 2001 by Sydney Ludvigson of New York University and Martin Lettau of the University of California, Berkeley. If consumers anticipate good times, they say, they’ll increase their spending in anticipation, which implies that a rise in spending relative to wealth will lead to rising share prices. And, they show, this is just what happened in the past. There’s wisdom in crowds; any single US consumer might be silly, but across tens of millions, the sillinesses cancel out. Right now, this is slightly worrying. Latest data (for Q3 2012) show that the ratio of consumer spending to households’ net wealth was slightly below average, pointing to slightly below-average returns.
Words of warning Of course, we shouldn’t exaggerate the predictive power of these indicators; they explain only a fraction of the variation in equity returns. And investing decisions rely heavily on individuals’ circumstances. On balance, though, there’s nothing in them that is horribly worrying, and some aspects that are currently quite encouraging.