Friday, 8 February 2013

The danger of positive thinking

With global stock markets in the midst of a major mood swing at the beginning of 2013, a new found optimism brings its own perils.

It is as if the market as a whole decided to focus on the positives as its New Year’s resolution.  Global stock markets have taken off in January 2013 as investors have shrugged off the worries that had weighed down on stock prices in 2012.  But while chronic pessimism has plagued markets over the past few years, the opposite has been the case in the New Year as stock prices have rebounded to levels which are tough to justify amid weak growth in the global economy.  So even though too much negativity has wreaked havoc in the markets, unfounded optimism can bring its own problems.

The prices of shares had been due for a rebound.  Investors had been on a knife edge with the potential for disaster seemingly around every corner as leaders in Europe dithered during the Eurozone crisis, politicians stepped up to the edge of the fiscal cliff in the United States, and the economy in China slowing during changes at the top of the Communist Party.  But along with Mayan predictions of the end of the world, all major catastrophes were averted in 2012 and this prompted a change of heart after investors returned from their holidays. 

Bonds are the typical haven for investors in times of woe and the past few years followed this pattern with investors having snapped up the bonds of prudent countries that have manageable debt levels even though interest rates have been below two percent.  Yet, bond prices have risen so high that further gains are not likely, but there were few other attractive investments at the time. And, as 2012 drew to a close, investors aching for higher returns had already shifted from the safer government bonds into the bonds of previously shunned countries such as Spain and Italy as well as corporate bonds. 

The new signs of life in the stock market tempted many into believing that the time was right to take on more risk and cash in their bonds to place a bet that improvements in the global economy would pick up pace in 2013.  This scenario has prompted talk of a “great rotation” as a swing in sentiment prompts investors into moving money from bonds in stocks.  The continued printing of money by central banks to shore up ailing economies has also helped to buoy the spirits of investors.  This all suggests an abundance of cash which will be heading into the stock market.  Yet, although it makes for a nice story to help prop up share prices, it may just turn out to be a fairy tale.

One of the main sticking points is that, while share prices have rebounded, the outlook for the global economy is still grim.  Higher share prices need to be backed up by companies generating larger profits and this cannot happen until the global economy has regained more vigour.  While an economic armageddon has seemingly been avoided in 2012, growth in the global economy will remain sluggish as high levels of government debt in many countries are trimmed back over years of austerity (for more details about Europe in this context, see Both Good and Bad News for Europe).  

Despite the holes in the story of the “great rotation”, many investors have been keen to believe in a new beginning.  Even the temptation of dubious scenarios can draw buyers back to the market due to concerns about being left behind if the market rebounds.  Investors also buy on expectations of what will happen in the future rather than based on the here and now so a dramatic improvement in economic growth in the following 12 months could prove that now is the right time to buy.  But with many having suffered heavy losses as share prices plummeted during the global financial crisis, a false dawn will do little to reassure investors that it is safe to return to the market.  An overly inflated stock market will also create a conundrum for central bankers and may prompt them to tighten up monetary policy while the economic recovery is still tenuous.  So here’s hoping that investors wake up from the pipe dream of soaring share prices before it turns into a nightmare.  

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