Bill Jamieson: Taking a defensive position could be sensible

WHAT is it that stock markets know that the rest of us don’t? Despite a near brush with a third recession, glacial growth performance and signs that the global economy may be slowing, stock markets round the world seem to have thrown caution to the winds.

Bill Jamieson

In the UK, the FTSE 100 index has climbed for seven trading days in succession, its longest winning streak since July 2011. It climbed 1.6 per cent last week to 6,625, hitting another five-year high.

In the United States, the S&P 500 has hit a succession of record highs. In Japan, the Nikkei 225 soared a further 6.7 per cent last week. And even in the troubled eurozone, the Eurofirst 300 Index climbed by a further 1.2 per cent to hit a five-year peak. What explains this astonishing burst of optimism? And does it mean we should pay no heed to the old stock market adage about selling in May and not buying any shares until September?

Shares around the world continue to be driven higher by an extraordinary burst of monetary loosening by major central banks. In the US, the UK, Japan and the eurozone, there has been resort to quantitative easing or its domestic equivalent to flood the banking system with money to stimulate commercial bank lending and business borrowing and investment – ­anything to get the world’s biggest economies back into growth mode.

The results so far have been fitful and slow to emerge. But the effect on financial assets has been dramatic. First, the sense of crisis that had gripped markets in the aftermath of the banking crash has passed. The message is that central banks will do “whatever it takes” to stimulate activity.

That flood of money has to go somewhere. It has seeped out into equity markets and fuelled a global buying spree – further encouraged by ultra-low interest rates.

Investors, faced with derisory returns on fixed-interest saving accounts, have been driven into the stock market, building portfolios of defensive shares such as utilities, pharmaceuticals, food and drink producers, where dividend income has offered a better return than bank deposits.

And the rally has a big self-feeding element. Stock market levels have traditionally been seen as predictors of the state of the economy 18 months to two years out from now. On this basis, world markets are signalling better times ahead even if in the here and now we are still stuck with low growth. That itself should help to lift business confidence. There’s also nothing like a 20 per cent rise in share values to encourage a sense of financial well-being: millions of investors will have checked their individual savings account (ISA) holdings in the past few weeks and found themselves better off than a year ago – enough, perhaps, to lift consumer spending and encourage households to buy big-ticket items.

However, there is that old precautionary proverb in the UK market – “Sell in May and go away until St Leger’s Day” – traditionally the second Saturday in September. This advice is by no means confined to the UK – the American version of the saying uses Halloween as the end date.

It is a fact that, on average, shares around the world tend to do less well between May and October than they do over winter and into the following spring. But, as with so many market wisdoms, it is unreliable; investors would have lost out last year by following this advice. Nevertheless, there is a tidal pull at work. And this year, we may have particular cause to pay attention.

I am grateful to Chris Dillow, the veteran sage of the Investors Chronicle, for a breakdown of sector performance based on price changes since 1987. This shows almost all sectors are seasonal, doing better in the winter months. The only exception is the utilities sector. The least seasonal sectors are defensive ones such as tobacco, food retailers, telecoms and pharmaceuticals.

What explains this seasonal variation? Dillow points to an obvious factor: investors tend to be more optimistic in the spring. Is it not natural that these feelings of optimism can tend to excess and run the risk of inevitable correction?

After share price gains of 20 per cent and more over the past 12 months, we may now be vulnerable to such a correction.

There is another reason to bear this caution in mind. Central bankers are no less prone to excess than the rest of us. For the moment they are pressing heavily down on the monetary accelerator. That pressure is likely to be maintained until there are clear signs of sustained recovery.

However, by the time that consensus is reached on the recovery evidence, central bankers will have overshot on the stimulus. Faced with the fear of generating an asset price bubble, the brakes will be quickly applied. We will go quickly from record low interest rates to a series of rate rises to prevent over-heating. However, judging how long to stimulate and when to remove the stimulus is not, and has never been, an exact science.

So investors might do well to hold back on chasing the cyclical hot stocks and sticking for now with defensive, income orientated shares. Beware of over-exuberance.