In December 2006, Schroders head of Asian equities King Fuei Lee gave an investor presentation with a slide entitled “Still More Signs of Market Irrationality Worrying Us”. Shortly afterwards there was a global recession and stock markets across the world began to tumble. In that slide he identified seven key indicators of market irrationality – five of which he says are now visible in the global markets.
“In 2006 I was worried by how irrationally markets were behaving,” said Lee. “It wasn’t enough to simply invest in undervalued companies with strong balance sheets, my investing methodology was not effective. I compiled a list of indicators that I thought revealed bubble-like trends in the stock market – and an alarming number are flashing again today.”
The first on the list is the VIX volatility index which is at a historically low level compared to the past 20 years. Lee says this is nonsensical when you consider the significant geo-political risks around.
“The volatility index shows how complacent investors are. Is the world ‘fine’? There are Russian sanctions, Middle Eastern crises, Brazilian and Indian elections and a lack of economic growth in Europe, yet volatility is at very low levels. This disconnect worries me,” he said.
Similarly, against this complex backdrop Lee says it would be logical to expect global stock markets to plateau, or even fall. Yet, with the exception of Japan all indices are higher now than they were before the credit crisis – but fundamentals are nowhere near as positive.
The US stock market in particular is significantly higher than pre-recession levels, and the emerging market aggregate index has recovered losses – and had an extra boost.
Another of Lee’s key indicators is whether momentum or value investing is delivering better results for investors. Momentum investing is the style of buying winners – stocks that have already performed well and that may be expensive compared to their peers – and selling losers. Value investing is the opposite, identifying and buying stocks that have underperformed and are undervalued compared to the rest of the market. Before the Asian banking crisis, the technology bubble bursting and the recent global recession there was a protracted period where momentum investing outperformed – before a switch to value investing. This pattern has just been replicated in markets.
Add to that irrational bond yields – US government bonds should not be paying the same as much riskier Spanish bond yields – and commodity currencies becoming uncorrelated from their fundamental drivers and Lee says he is nervous.
He is not the only fund manager taking a cautious stance. Jan Dehn, Head of Research at Ashmore highlighted this week that emerging markets are facing considerable uncertainty – Brazilian presidential candidate Eduardo Campos died in a plane crash and India delivered “a genuinely unpleasant set of macroeconomic numbers this past week”.
Lee says that rather than worrying about what the catalyst for a market implosion may be – interest rates, inflation or elections – investors should instead prepare for the crunch.
“Invest cautiously,” he warned. “And tread with care.”
