Bad mood equals good sharemarket returns

Roller-coaster: Equities may give investors a rough ride now but offer a long-term option The New York Times

Imagine for a moment there is a parallel universe where the United States and European governments are running surpluses, Japan is partying like it’s 1989 and the phrase “Chinese hard landing” has never been uttered.

One would think such a paradise would be a great place to buy shares.

Not so, says Nader Naeimi, the head of dynamic asset allocation at AMP Capital Investors.

“In fact, investing is much riskier when based on the widespread belief that there are no risks,” he says. “In a low-return and volatile world, the cyclical swings in markets can provide significant profit opportunities for a few who are prepared to exploit the opportunities that often result from investors’ herd behaviour.”

Naeimi is not your typical funds manager, pre-programmed to talk up the sharemarket.

As his title implies, Naeimi’s team makes its money by dipping in and out of any asset class it likes. Shares are just one offering on the smorgasbord, yet Naeimi is still gravitating towards them.

He acknowledges that the unfortunate macroeconomic reality – the European debt crisis, multi-year lows in most measures of consumer and business confidence, deleveraging in the developed world, peaking company margins and falling earnings – has had a strong correlation with the poor performance of equities in recent months.

This does not imply poor future returns, he insists.

“While it makes sense to expect poor returns from equities and other growth assets given the ominous macro backdrop, the fact that the challenges to growth are so widely known should provide little guidance to future returns,” he says.

“In fact, historical analysis shows that there is little or no consistency in the predictive power of macro indicators or earnings growth expectations on future market returns.”

To illustrate the point, Naeimi looked at several years of purchasing manager index data for the US, Europe and Australia and found that when these popular gauges of sentiment were at their lowest, the subsequent 12-month equity returns turned out to be the highest.

While he’s confident that weak earnings do not necessarily translate to weak future returns, nor strong earnings to strong returns, Naeimi says earnings data and the macro picture should not be dismissed entirely.

“Indeed, a sustained and durable move higher in shares requires a strong support from earnings growth and a healthy macro backdrop. There is, however, an important caveat,” he says.

“The macro impact becomes insignificant and often counter-intuitive as it becomes conventional wisdom.”

In other words, the fact that Europe is in recession is nothing new. There is even a silver lining because the bad news has already been priced in, yet central banks continue to ease monetary policy.

This means the equity risk premium (the gap between nominal bond yields and earnings yield on shares) is at multi- year highs above 4 per cent in big markets, with dividend yields well above cash rates to boot.

The price you pay for buying shares now is a short-term roller-coaster ride.

“Investors tend to give up at the worst possible time when volatility becomes too much to handle,” Naeimi says.

The emotional response by investors to quit creates strong profit opportunities for those prepared to turn off the TV, ignore the headlines and think
long-term.

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