Following a rising stock market is an easy way to make money but share prices can only defy gravity for so long
Something strange is in the air among investors – a pervading sense of calm. Volatility in financial markets has dropped off while stock prices are near record highs. These conditions seem out of place at a time when there are a number of reasons to be jittery - the economic recovery is far from assured and central banks are set to raise interest rates. The buoyancy of the financial markets says more about the habits of investors than the actual state of the economy.
One defining feature of investing is that it can be easier to make money by following trends rather than fighting against market momentum. The only problem is that the trends become a force in themselves and can push prices too far either up or down. This effect can only be temporary as markets must revert back to normality at some point. This leaves investors caught between making money when times are good and making a getaway before profits are wiped out. This day is drawing closer. Your Neighbourhood Economist can’t predict when it might happen, only that a reckoning is likely to be just around the corner.
Financial markets are notoriously hard to read. Theory tells us that the prices of shares are based on a combination of all available relevant information. Yet one of the most pertinent reasons for buying or selling is the past price movements. Financial assets are one of the few things that we buy more of as the price rises and are more likely to sell when the price falls. This can often override other considerations such as whether a company is expected to see its profits grow in the future. Base instincts such as greed and fear can also take over and distort our investment decisions.
The tech boom and bust just over a decade ago was a classic example of this. Investors threw money into start-ups whose ability to generate revenue was questionable. You did not even have to believe that the Internet would revolutionize business, just that others would and that these others would keep buying so that you could make a tidy profit and sell up. Thus, prices often deviate from what shares in a company might actually be worth depending on the likelihood that someone else might be willing to pay more for the shares sometime in the future.
This is not to say that money cannot be made by holding onto shares in profitable and well-managed firms. Yet such an investment policy will only work out in the long term with the timing of when to buy and sell also being crucial. The bulk of investors, however, are not trading in shares over the long term. Professional investors looking after other peoples’ money tend to actively buy and sell to take advantage of short-term trends. This proactive approach is also used justify (and amplify) their considerable fees despite often being unable to outperform market benchmarks.
Actually, it's even more complicated
Gauging where shares might be heading is further complicated by the current expansive monetary policy. An abundance of cash in the financial system means that people wanting to buy financial assets are never far away. Pushing share prices to unrealistic values is just one example of how monetary policy is creating problems. Policy makers need consumers in an optimistic mood to get spending up and creating extra wealth through the stock market is one of the few ways of getting us in a more cheerful mood. It can only provide a short-term boost and might work in the opposite direction when this policy is reversed. The jolt from the inevitable interest rate hike which is likely to disrupt the market calm may result in more than just some investors losing their easy gains.