Share price falls: a blip – or start of a bear market?
How can investors decide what the stock market correction means for their portfolios? Richard Evans reports
How should investors interpret the dramatic events on the world’s stock markets of the past week or so? Amid the flood of figures and commentaries, it’s worth keeping some basic principles in mind.
Share prices are determined by economic fundamentals and sentiment. We’ll return to sentiment later, but the two key economic factors that drive stock markets are companies’ expected future profits and the returns available from other assets.
The outlook for corporate earnings is relatively good, thanks to decent and coordinated economic growth across the world. But profit growth is not strong enough to justify a continuation of the kind of rises in stock markets seen over the past year – except perhaps in America, where President Trump’s recent cut in corporation tax rates will provide a large boost to companies’ profitability.
Put another way, an optimistic outlook for global growth does not mean that stocks can gain 20pc year after year.
This does not prove that markets are currently overvalued (although some valuations are much higher than their historic norms, as we explain on pages 2 & 3), just that this aspect of the economic fundamentals does not support continued rapid share price rises. This is especially so when we consider the second aspect: the returns available elsewhere.
One of the main causes of the bull market in shares has been central banks’ policy of low interest rates and “quantitative easing”. These programmes sent returns on cash and bonds respectively to rock bottom. But the policies are now in reverse in America and some other economies, boosting cash savings rates and bond yields. In the US, which sets the tone for all financial markets, yields on twoyear government bonds have breached the 2pc level, while 10-year bonds yield almost 3pc.
“Two per cent is the kind of level where savers and investors start to get interested again,” said Alasdair McKinnon, manager of the Scottish Investment Trust.
On some previous occasions, dramatic falls on Wall Street have prompted America’s central bank, the Federal Reserve, to delay rises in interest rates in a bid to stem any flow of money away from stocks and into cash or bonds. But it now appears to be confident enough about the strength of the economy to let matters take their course.
In other words, investors in America, and by extension those elsewhere, can no longer rely on the Federal Reserve to come to the rescue if the stock market falls.
What about sentiment? Until this correction the US market had been rising more or less consistently since the lows of 2009, with some sign of acceleration in recent months – sometimes seen as signifying the final stages of a bull market. Rises in Britain had been more muted.
All told, the rise and fall do not seem to embody the kind of drastic and sudden change in attitude seen, for example, in the bursting of the dotcom bubble (for more on how markets have behaved after previous corrections, see page 2).
The rise in markets that began in 2009 was sometimes called “the most unloved bull market in history”, which also suggests a more equivocal stance on the part of investors and less scope for a disastrous reversal in mood. Many investors also kept money in the sidelines in cash, ready to invest the moment they scented a bargain.
We should also remember that stock markets are heterogeneous beasts and not all stocks rise and fall together. The Telegraph’s Questor column has recently favoured stocks and investment trusts that seem able to offer strong, non-cyclical growth or undemanding valuations. For four examples, see page 3.