An independent professional's take on the latest news and trends in global financial markets

Hoping for the best in 2011

The strategy team at Societe Generale, regularly ranked the best in the City, despite their idiosyncratic ways, chose a useful title for their annual presentation last week on the outlook for markets in the year ahead.  Hoping For The Best, Preparing For The Worst neatly summarises the bipolar nature of where I think we are in the cycle – not much to play for in terms of long term returns, but nevertheless some good reasons to think that the current market recovery can continue into 2011.

Here are a couple of keynote charts from their presentation.  One shows where the US market sits on two well-known long term valuation metrics, a cyclically-adjusted p/e ratio (named after Prof Robert Shiller, the US academic who popularised the methodology) and Tobin’s q, which measures the ratio between the current value of the equity market and the replacement cost of its component companies’ assets.

On these measures, the US equity market looks fully valued. On other occasions in the past when valuations have been in the top 20% of historical averages, future ten-year returns have been poor; on average, just 1.4% per annum, as the second chart shows.

But value measures, while a powerful indicator of future long term returns, are a poor guide to shorter term movements, where momentum, the interest rate cycle and sentiment have a much greater role to play.  There are a number of reasons for thinking that this year could still turn out to be a good one for the equity markets, notwithstanding one other major cause for concern, which is the dangerously high level of bullish consensus amongst advisors and brokers.

The percentage of bullish advisors in the long running Investors Intelligence sentiment series, for example, has recently risen to a very high level, which traditionally points to the imminence of a correction.

The message from this is the need for considerable caution. That is not quite the end of the story however, as Tim Bond, the former Barclays Capital strategist, now working at Odey Asset Management, made clear in his first quarterly call for his new firm last week.  In his view equity markets, in both the United States and some other developed countries, are potentially in a sweet spot, as earnings rise strongly on the back of a better than expected economic recovery and interest rates have yet to rise to meet the inevitable inflationary pressures that are already evident in the UK and elsewhere.  Demographic pressures will be starting to drive a secular increase in bond yields in the next year or so.

The overall picture is one of  those dangerous but exciting periods in markets where short term and long term indicators are pointing in different directions, with attendant increases in both potential risk and return.

Written by Jonathan Davis

January 24, 2011 at 11:40 AM