Confidence – the market driver that matters
 

‘Thoughts speculative their unsure hopes relate,
But certain issue strokes must arbitrate’

Macbeth

The only certainty about financial markets is that nothing is certain. We sometimes envy other professional men and women like doctors, architects, and engineers, whose work relies on unchanging laws of the physical universe and a chain of predictable cause and effect. Within the endeavours of natural science, much can be reliably anticipated; within the melting pot of human emotions, which is our own field of observation, you never know what one moment holds for the next.

That is not the perception which Sid – Britain’s investor at large – has of the way we look at things. All the marketing hype attached to the promotion of financial products implies the exact reverse, namely that wealth beyond understanding – but not beyond advertisement – awaits every discerning buyer of the Providential Rainbow Fund or Equivocal Endowment units, given the piercing foresight and peerless record of the investment manager on display.

Little wonder that a glazed look comes over friends, soaked in financial propaganda, who find it hard to fathom what is happening after the recent surge in equity markets in the first few months of 1991. They are bewildered partly because the investment professionals who claim so much appear to be as confused by it all as they are. And partly because the rise in the financial markets doesn’t seem to correspond with anything they recognise in the real world, much of it mired in deep recession. How can so-called experts be confident of giving any useful advice in a field so unpredictable as a stock market?

Well, if by ‘useful’ is meant, as the advertisements imply, quick or certain profit, the answer is they can’t. Our bankruptcy courts are thronged with investors who, though ready to face the rack rather than back a horse in the National, have sunk their life’s savings in promises made of straw.

The truth is that sudden changes in market direction have little to do with perceptible changes in the real economy. They are based on a change in confidence, that is, on a will o’ the wisp which tilts the balance of greed and fear and alters the willingness of investors to take risks with their money.

In North America and Britain the increasing dominance of the investment institutions is shifting these mood swings further and further away from the events which they anticipate. If the market bounces 10% or so, managers of the giant pension funds and insurance companies, anxious not to be left behind in the dash for ‘performance’, rush to commit their funds and a rise of 10% all of a sudden becomes 20% as the market is flooded with cash.

When market prices rise or fall further and further ahead of the events they are supposed to discount, the overall movement is bound to look more and more bizarre to casual observers.

Strange though they look at the time, markets do not move in a vacuum devoid of all outside contact with the wealth creating process and shifts in confidence do have causes, however remote. Biggest of these by far is a change in monetary policy, for monetary policy determines the level of short interest rates, and anything that you do with cash has to be measured against the return from cash itself.

So important are short interest rates to investors, that, in the United States, where the Federal Reserve Board sets them more or less independently of the government, an army of ‘Fed’ watchers has grown up whose job it is to analyse the Chairman’s every word, smile, frown, or hiccup, to divine some hair’s breadth of meaning for monetary policy. And indeed the sharp falls in interest rates in the US and the UK in the early part of this year did improve investors’ confidence and so inspire the recent rally in equity prices.

Confidence springs from a variety of other wells, not all of them fathomable. Seeking a grain of certainty in the shifting sand of investors’ intentions, a further army of pollsters makes a living out of monitoring the sentiment swings of other money managers round the world in case they can get an early sniff of a mood change. This is an occupation of marvellous futility, rather like holding a mirror in each hand to see if any of the inner reflections will give a different picture from the first one.

At times observers of the financial world have to accept that the market’s mood changes, as it has, for reasons that even in hindsight are only partly explicable. A more important question is whether the present surge in confidence is likely to be sustained in the hard light of events.

What then are baffled but inquisitive investors to make of the UK equity market, up by a quarter from its trough, as they peer out into the darkness of recession?

It seems to us that a number of intangible factors have, so to speak, come right in the past few months, and they should give world equity markets a new and higher base.

The recovery of Kuwait by the allies was an initial plank of support, but a broader, stronger one has been the recovery by the United States of a position of long-lost hegemony among its political and military partners. Recognition of this new position lies at the root of the dollar’s recent surge upwards.

Markets may also be discounting a more important possibility, as we see it, which is that perhaps for the first time this century, a community of interest and purpose among the major nations, including the USSR and China, may be emerging. Divisions of course still exist, and little can be said with confidence about the USSR in its present state. Nonetheless, shared economic objectives such as the containment of inflation, the rescue of the East European economies, the reflation (perhaps) of the international banking system, and, let us hope, joint aid for the world’s starving, already suggest a sketchy outline for what could be a grand design.

A more practical consideration is that the world economy, tired after the expansion of the 1980s, offers little prospect of an early acceleration, and accordingly there is a premium to be paid for companies which can continue to grow despite a general slowdown. That is why many of the neglected smaller growth stocks in the United States have risen by 40 or 50% so far this year.

Here in the UK mounting political anxieties, together with a lengthening queue of company rights issues, suggest grounds for some caution about equity prices. Further doubts surround the timing of any recovery, which may come too late for the hard-pressed cyclical sectors.

What we have seen in the UK equity market is the easy part, the confidence shift, exaggerated as it has been by restless and cash-laden institutional investors. Progress from here will need to be supported by firm evidence of an improvement in the business climate and, what is more, without upward pressure on inflation or downward pressure on the exchange rate. In an election year all this is a tall order.

Little is to be gained from speculating about market movements tomorrow or the next day. The best investors can do is to weigh the probabilities over the months ahead, dispose accordingly and wait for the judgement of events.

Within the investment horizon as we see it, the main factors to be assessed are the consequences for sterling of a possible change of government, the implications for British industry of political and financial integration within Europe, and the lingering recession.

None of these will alter the direction of the UK markets overnight, but when and if they do, investors may be glad if they have stuck to the most basic of all investment principles, which is to diversify risk. Investors who respect that principle might want to have a sizeable percentage of their portfolios invested beyond these shores.

May 1991

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