Thursday, 13 June 2013

Caution – Windy Road Ahead

Trends in the stock market are hard to spot at the best of times but upcoming changes to monetary policy will add a few extra twists and turns.

Trying to work out the right time to buy or sell shares is like driving at night with a busted headlight – only some of the road ahead is visible and it is best to proceed with caution.  Evidence suggests that even the so-called experts struggle to negotiate the markets better than anyone else.  Everything from nutty dictators in North Korea to the latest iPhone can throw the markets into disarray.  The task of investing in stocks has been made even more difficult due to extra funds in the financial system stemming from central banks everywhere printing money.  The actions of the central banks has given shares an extra boost but the resulting gains are expected to fade with more cash likely to be less forthcoming as the global economy improves.  With monetary policy now dominating movements in the stock market, the prospect of changes by central banks are likely to leave investors hanging on the edge of their seats.

The basic premise of shares in a company is that it entitles the owner to a portion of the profits in that company.  The value of shares will rise or fall depending on the company’s ability to generate profits in the future.  While profits also rely on circumstances at each individual company, it is the state of the economy in which companies operates that tends to dictate the direction of the stock market.  So it may seem like somewhat of an anomaly that some stock markets such as in the US are hitting record highs at a time when the outlook for the global economy is so dismal.  The reason behind all this is monetary policy. 

Central banks were quick to slash interest rates to close to zero with the onset of the global financial crisis, but when the low interest rates were having little effect in terms of the prescribed goal of boosting lending, a new policy of quantitative easing was adopted.  Central banks started to print money and use this to buy bonds with the hope of making borrowing even cheaper.  Yet in spite of all of these efforts, consumers and companies have been stuck in a cautious mood and loathe to part with their cash which they have stashed away instead. 

The surplus funds end up being invested in assets such as bonds and stocks.  Bonds would be the preferred investment due to being a safer bet amid these turbulent times, but with central banks spending billions buying up bonds (which increases prices and reduces returns), the meagre pay-out from bonds has seen funds flow instead into the stock market.  The extent of these cash flows is such that it is vagaries of monetary policy that have come to dominate the direction of share prices.  The underlying health of the economy only registers to the extent to which it has an effect on the bond buying of central banks and has created a paradoxical situation where bad news regarding the economy is good for shares as weak economic growth translates to continued action by central banks.

The return of growth in the global economy may help to cushion any weakness in share prices as the central banks wind down their operations.  In theory, steady economic growth ensures that corporate profits increase over time, and thus, the value of stocks is typically on an upward trend.  But with the possibility of ups and downs in the global economy, shares may end up being overpriced depending on the extent of a potential correction in the market due to the change in monetary policy.  The potential for a correction in the stock markets makes it tricky to call whether it is a good time to buy or sell with the added uncertainty likely to make for a bumpy ride if you have the stomach for it. 

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