A canine’s nose for markets
It seems my pet dog has recently developed sensitivity to the markets because throughout January, he was a particularly poorly boy. While at the vet, the Australian nurse examining Monty found out I was a fund manager, so started quizzing me on the state of the share market. Trying to explain a preference for Wells Fargo over Bank of America Merrill Lynch to the tune of a whimpering animal is quite a surreal experience...
My clearly distracted vet wanted to know whether the current falls in equities were a buying opportunity or the start of an even greater price collapse. I told him – not advice, of course – that I felt equity markets are too noisy to be a good short-term indicator. That got me thinking that investors too often focus on equity markets without paying enough attention to its boring cousin: the bond market. People are looking in the wrong place for clues to our economic future!
According to equity markets, the chance of economic apocalypse is but a coin toss, yet looking at bond markets; things are nowhere near as dire.
Yes, credit spreads for US high yield energy debt have spiked beyond levels seen during the global financial crisis. But investment grade corporate debt has barely risen, except to account for the expected tightening of US monetary policy. Similarly, sovereign bond markets are not ringing alarm bells. Meanwhile, equity markets have dropped sharply over January, eliciting warnings to sell all equities and run for the hills. Why the disconnect? Bond markets are much more sensitive to economic data, and (usually) move in ways that appear more logical than equity markets over the shorter term.
So why do equity markets tend to be a terrible forecaster of our economic future? Large macro drivers are sometimes missed by the sell-side brokers that create most of the research on equities. Much of this tends to focus on specific operations of the stock in question. However, occasionally the focus on the detail, which is usually very thorough indeed, means larger macroeconomic themes or disruptive events are not always spotted. Also, equity markets tend to be more heavily influenced by sentiment. The opportunity for theoretically boundless upside, and the diametric vulnerability if a company fails, may sway some investors more than the facts would inform.
Take Microsoft: it was top dog of computing for decades, until it wasn’t. Users overwhelmingly demanded accessibility rather than utility, spurring the renaissance of Apple and casting Microsoft into the wilderness for years. It remains the ultimate value trap. Or oil companies over the past 18 months - their earnings were blown out of the water when the price of oil fell through the floor.
In both these cases, estimates of free cash flow and return on equity were suddenly eclipsed by something greater. Analysts would not have seen that in spreadsheets. This is not to say there are not very diligent analysts with dexterous minds. It’s just that first and foremost equities are looked at in isolation. Bond markets, on the other hand, are always looked at in relation to the greater macroeconomic picture. The relative nature of this analysis is embedded in the terminology. The number one metric for fixed income investing is bond spreads: the extra returns offered above government yields, which give the fundamental health and monetary outlook for an economy.
Look at the correction in developed market share prices over the past few months. They have dropped substantially more than the earnings they are supposed to value as investors worry about the prospects for future growth and the potential for global recession - this despite a distinct lack of doom-laden economic data.
I think the global economy is in a similar state to my dog. It was in very poor shape, but aside from a few wobbles, it’s on the mend. And perhaps the stereotype of the Belgian dentist is changing: there’s an army of stockholding Aussie vets out there, pouring over the markets.