Andrew Bell, the new CEO at Witan Investment Trust, warns of the perils of investing in the latest market themes.

In wildlife films antelope on the Serengeti become excited at the prospect of rain even when there is no cloud on the horizon. Similarly, financial markets have a tendency to try and look around the corner for the next theme, often falling in the face of good news and rising in the teeth of discouraging news. However, with publicly known facts already factored into market prices, investors often react to new information out of proportion to its significance.

The desperation to catch the next theme or market cycle can (as in 2008) lead to exaggerated swings, particularly at times when confidence is shaky. The markets’ economic forecasting ability may well be less reliable than the average wildebeest’s ability to sense rain from afar and seek out fresh grass – comments are often made about the stock market having discounted ten out of the last five recessions. The collective search for the best place to allocate capital leads to a profusion of false signals.

There are two serious points here. The first is that in investment terms you have to drive using the windscreen not the rear view mirror. The stock market is addicted to the windscreen. Secondly, the wipers and screen demister do not always work, so the direction and speed of motion should not be unquestioningly followed. Momentum is a treacherous guide at turning points.

At present, the market appears particularly unsure of its direction. Having seen economies delivered from the threat of depression last year, by virtue of a “whatever it takes” stimulus from governments and central banks, equity markets and other risky assets (such as corporate bonds and property) enjoyed a strong rally in 2009. Looking forward a year ago enabled investors to benefit from an improvement in economic conditions.

2010 seems likely to be more complicated. First of all, valuations are higher. Better economic news will be needed to support higher investor hopes. Secondly, governments are under pressure to reduce surging budget deficits. This is likely to represent a headwind for economic growth, which central banks will struggle to offset, with interest rates already close to zero. Thirdly, banks are under pressure to strengthen their balance sheets – good for stability longer term but bad for lending shorter term. Fourthly, over-borrowed consumers in countries such as the UK and the US are saving more. So, there is a strong possibility that the economic recovery will be anaemic by past standards. Having moved from rigor mortis a year ago to anaemia now may be insufficient to refresh all the more economically sensitive parts of the economy (and stock market).

As markets have started to dwell on the risk that the recovery may stall or that monetary policy tightening will put pressure on valuations a more apprehensive mood has overtaken global equities, which have unwound their year-end rally. Issues as diverse as Greek budget deficits, debts in Dubai and the prospect of a tightening in global fiscal and monetary policy have led to a renewed focus on risk, ignoring other news from corporate earnings and economic growth that suggests the economic recovery is being maintained. So, is the rally in 2009 over or are we living through a transition from markets driven by hope and liquidity to those driven by fundamental improvement and delivery against forecasts?

One indicator to watch is forecasts for economic growth in 2010 and 2011. In recent months, 2010 forecasts have been steadily improving, although the rate remains low compared with previous exits from recession. 2011 growth is forecast to be slightly higher than in 2010. If those forecasts hold steady or improve, growth hopes in the equity market will be reinforced.

Investors are also fretting that central banks will tighten policy too much, tipping economies back into recession. This could either arise from a policy misjudgement or because bond investors (unsettled by high government borrowing) become worried about inflation risks and push yields higher. When activity was depressed, these concerns were put to one side but with activity reviving the risks of inflation picking up are harder to dismiss. 

The G7 Finance Ministers have recently reiterated their intention to continue to deliver economic stimulus measures, while making plans for retrenchment once the recovery is firmly established. This suggests that there is no desire to tighten sharply or imminently.

Even the relatively hawkish European Central Bank seems unlikely to act aggressively given the PIGS’ economic problems (Portugal, Italy, Greece and Spain) which face domestic fiscal austerity while being part of a (till recently) strong Euro. In China, early moves to tighten bank lending seem driven by a wish to reduce growth to below 10 per cent (to prevent overheating) rather than to bring it to a juddering halt. A tightening “overshoot” seems unlikely.

The stock market sometimes seems to have the attention span of a hyperactive goldfish but the real economy moves more slowly. It will take some months before it is clear whether economic recovery is being sustained and for governments to find the right fiscal balance - taking decisions to reduce future borrowing (necessary to maintain bond investor confidence) but deferring implementation to prevent a relapse into recession. During such transitional phases (2004 was another one) patience is required and an emphasis on fundamental improvements rather than the more mercurial blandishments of momentum.