Comment: What to believe: the good, bad or ugly

Buoyed by the continuing strength of the FTSE 100 this autumn, I e-mailed my investment adviser, Miss Hazel Eyes, to check on the value of my investments.

The Princess of the Portfolio Print-out had indeed good news. It lifted the gloom of a wet and miserable day. But I was seized by doubts.

From experience I have learned that when I do this – typically following a good run in the markets and when I start to worry about being too defensive on my ISA fund choices – it is followed by a market correction.

Has the past year been too good to be true? Back in the second week of November 2012, the FTSE-100 was at 5,605. Today it is standing at 6,734, a gain of 20 per cent. Equities world-wide – with the exception of emerging markets – have risen even more strongly. There has been a stream of upbeat news on the real economy – though economic growth and stock market performance by no means move in synch.

Markets have also been helped by quantitative easing and the reluctance of the US Federal Reserve to begin QE tapering. The recovery, so far, is notably weaker than previous cycles.

This has seen the bizarre phenomenon by which “bad news”, causing the world’s central banks to stick with unprecedented monetary loosening and ultra-low interest rates, is hailed by the markets as “good news”. Conversely, evidence of better-than-expected economic data revives concern about QE tapering and markets sell off – “good news” is “bad news”. Now markets are all about anticipation – it’s perceptions about future company earnings that matter, and here we come across some strange anomalies.

John Wyn-Evans, head of Investment Strategy at Investec, has highlighted these in an outstanding weekly note. This year, he notes, has been good for equity investors. The MSCI World Index is up 17.8 per cent for the year to date in dollar terms.

Some individual markets have done better. The S&P 500 is up 19.8 per cent, while the Topix of Japan is up almost 24 per cent. Compared with these the UK’s All-Share Index looks sluggish with a gain of 14.2 per cent. Emerging markets are the big loser, down 4.2 per cent.

But what, he asks, has happened to earnings forecasts during this period?

“Global earnings estimates are 2.4 per cent lower than they were at the start of the year. US earnings estimates in aggregate are about 1 per cent lower this year; pan European earnings forecasts for 2013 have fallen a whopping 9.8 per cent. Only Japan breaks the mould, with earnings forecasts 8.7 per cent higher than at the start of its financial year in April”.

For the last three years analysts, he points out, markets have entered the year expecting around 10 per cent earnings growth and ended up with far less. Earnings are now forecast to end 2013 about 12 per cent higher than at the end of 2010. However, over the same period the market has risen 26 per cent.

In Europe, market earnings forecasts for 2013 are in fact marginally lower than they were at the end of 2010, yet the market has risen almost 15 per cent.

What’s driven markets is that worst fears have been avoided: the eurozone crisis has been cauterised (so far), the much-predicted hard landing in China has been avoided and the US government has not been shut down. As a result, equity ratings have risen. But with valuations now closer to historical averages, they now need to be underpinned by stronger earnings – and from revenue growth, he insists, not cost-cutting.

Thus it is that the year that saw economies moving towards “escape velocity” may also see the end of this bull run.

This doesn’t automatically mean that a fall-back from today’s level is imminent or needs to be sharp. But some are not prepared to take the risk.

Bill Eigen, manager of the $9.4 billion JPM Income Opportunity fund, warns that even cautious investors who have taken shelter in fixed income would be better off holding a proportion of their assets in cash. He holds some 56 per cent of his portfolio in cash.

He told TrustNet this week he is waiting to take advantage of impending volatility in the markets when there will be more investors looking to sell. He says the biggest headwind facing fixed income markets today is the mess in the US government.

These are the doubts that bubble up on today’s cheering valuations. It may be some time before I dare e-mail Miss Hazel Eyes again.