FORECASTING MARKETS WITH A TOSS OF A COIN
By John Authers
Financial Times (UK)
December 30, 2006
Guildenstern: "Consider -- One: Probability is a factor which operates within natural forces. Two: Probability is not operating as a factor. Three: We are now held within un-, sub-, or supernatural forces." Rosencrantz: "What?"
In Tom Stoppard's play Rosencrantz and Guildenstern Are Dead, Rosencrantz tosses a coin 99 times and it comes up heads every time. The chances of this happening are, of course, infinitesimally small but this does not mean they should keep calling "tails." The fact that the last 99 tosses have come up heads still leaves the odds that the next toss will come up heads at exactly 50 per cent. It is as well to remember this when trying to forecast world markets for next year.
A number of trends have been consistent ever since the bursting of the internet bubble in 2000. The world over, small companies and the value style of investing have outperformed year after year. So has gold, so have industrial metals, and so has property. At an international level, so have the emerging markets. And, since equities hit a bottom in late 2002, equities have been a good place to be. At some point, these trends will pull back towards long-term averages. But there is still no particular reason to expect these trends to reverse in 2007.
However, if the efficient markets hypothesis is correct, then the coin-tossing analogy is a good one. It holds that all information is incorporated into asset prices. Thus only new information will change them. This implies that there is no point playing the annual game of predicting next year's market moves, as to do this would require information that is not yet known.
Of course, markets tend to overshoot, even if they attempt to incorporate all known information. So perhaps we can get a handle on 2007 by asking whether markets look mispriced. Then we can ask what new information could move prices in the new year.
Those who think they have the answers to those questions can then predict the markets for 2007 -- though they should not forget what happened to Rosencrantz and Guildenstern.
Do markets look reasonably priced? With respect to equities, the answer is yes. Earnings multiples did not change much during 2006, and look reasonable in relation to bond yields and to historical norms. Continuing phenomenal earnings growth surpassed the most optimistic forecasts. Equity fund managers' assessments are almost universally bullish.
James Swanson, chief investment strategist at MFS Investment Management in Boston, puts the case well. Moving into a recession, he points out, debt-to-capital ratios tend to worsen, as does interest rate coverage, while cash flow margins decline. All these measures are, in fact, improving. Corporate profits are nearing historic records as a proportion of GDP, while cash flow margins are also at all-time highs.
So the corporate sector is in good shape. Profits should continue to grow and the multiples payable for those profits are not excessive.
Outside equities, however, valuations look extreme. The spreads payable for the extra risk involved in corporate bonds over government bonds, or on emerging market bonds over U.S. treasuries, are at all-time lows. This explains why private equity firms have bid such high prices to buy out companies -- the credit market is giving them cheap finance.
But the U.S. treasury market has an "inverted yield curve," the term for conditions when long-term interest rates are higher than short-term rates. This normally prefigures a recession, or at least an imminent sharp cut in base rates. Declining Treasury bond yields also imply that the market is expecting the Fed to cut rates soon. This implies heightened default risk, which would damage the credit markets -- exactly the opposite of what has happened.
A blow-up in the bond and credit markets could mess up the rosy scenario for stocks. So the key questions for 2007 concern the bond markets. First: will the Fed start cutting rates early in 2007? The bond market plainly believes that it will. If the answer is no and if rising inflation forces the Fed to raise rates, it will be bad news for equities. This would tighten the stream of liquidity that has left companies awash with cash. Second: will the troubles of the U.S. housing market affect the rest of the economy? If falling house prices force U.S. consumers to reduce spending -- and Swanson of MFS points out that a year-on-year reduction in consumer spending has not happened since 1938 -- then the Fed would certainly cut rates. A recession would attack profits, while the specter of mortgage defaults could wreak havoc with the positive scenarios priced into the credit market. But if you answer "yes" to the first question, and "no" to the second -- and both answers look very plausible -- then you have reason for optimism.
A final question concerns geopolitical risk, which can render irrelevant all the carefully calibrated probabilities of economic and market cycles. Markets have grown used to political risks since 9/11. But there is one risk for 2007 that worries them: a U.S. conflict with Iran. The implications for the rest of the Middle East and for the supply of oil would be horrendous. Swanson suggests it would mean crude oil at $100 per barrel. If this happens, everything else becomes moot. The world would fall into recession. On balance, war in Iran looks unlikely for many reasons. But if you feel confident about the markets in 2007, you need to answer no to the question, "Will there be war in Iran?"