Investors should brace for stock market falls in 2014
Richard Harris explains why he expects stock markets to rise in the first half of 2014 - before tumbling when the severity of risk factors becomes clear. The key for investors is to spot the signs early
Even after 200 years or so of modern stock market analysis, it is still very difficult to fathom the markets. Prices react to the same news in a different way or different news in the same way, depending on what has gone on before, and on the news already accounted for in prices.
It makes looking ahead exciting and exasperating in different measures, depending on whether or not one is making money.
The latest lesson learned, in my 35 years of experience, is how important psychology is in the behaviour of the market. The Nobel Prize for economics was awarded this year to three behavioural economists: professors Eugene Fama, Lars Peter Hansen and Robert Shiller. Fama is a proponent of the theory that market prices incorporate all known news, while Shiller holds that investors can be slow on the uptake or show irrational exuberance.
Both are right in their own way - it is the job of market observers to predict when and under what conditions who is right.
Most analysts are forecasting that 2014 will be a good year for investors. There is a genuine consensus that the "engine room" economies of the US and Europe are picking up and this is likely to drive the momentum of the markets, creating an upward trend that I expect will last for four to six months.
One or two naysayers are talking about a crash. But what is a crash? If the markets fall by 15 per cent after a rise in 2013 of around 25 per cent on Wall Street, is that a crash? Or is a 5 per cent return over two years what we should be expecting in this market environment?
The coming year is going to be one - more than 2013 - when the psychology of the market will have an impact on investors, and it will be much more difficult for investors to manage. It is likely to be a stock picker's market, with market indices going up much less than in 2013, but with certain shares doing very well.
I expect a single-digit rise in Wall Street in 2014 - an acceptable rise in most years - after a strong first half of the year. So that means sometime in the year, there needs to be a notable fall. The secret of success in investing next year will be in taking advantage of the momentum in the first half of the year and then spotting the fall - before it happens.
To assist our timing, it is helpful to refer to that "great market behavioural psychologist", former US defence secretary Donald Rumsfeld, and utilise his famous analysis of "known knowns", "known unknowns" and - the most feared of all - "unknown unknowns" to make sense of market risks.
The list of "known knowns" comprises risk factors that will certainly affect 2014, such as the huge amount of liquidity in the system. The latest "unknown" to become a "known" is the January date of the start of the US Federal Reserve's tapering of its market liquidity injection, called "quantitative easing" by the Fed and money printing by others. These "knowns" are incorporated into the market's psychology, and as they are neither a shock nor a surprise, they will mildly influence prices as the risks work themselves through.
However, a known risk may later increase in severity or be a symptom of an even bigger risk and become an "unknown known".
The "unknown knowns" for 2014 (or perhaps 2015) are factors where the timing or severity remains uncertain. These include the expected drop of high corporate profitability and the size of China's shadow banking and debt levels. If the particular risk is not severe, the market is not overbought (or oversold) and if the timing does not come as a shock, the impact of the news will be less than otherwise.
The "unknown unknowns" are risks that take time to generate and are often found in combination with other risks - so that the degree of severity can be under- estimated for long periods. The moment of appreciation of the seriousness of the combined risks typically comes as a sudden shock to the markets and it is this, usually from elevated price levels, that will trigger the next bear market or financial crisis.
If the usual cycle of five to eight years is upheld, 2018 may not be a good time to be fully invested.
A common theme of the autobiographies of former US Treasury secretary Henry Paulson and former Fed chairman Alan Greenspan is the shock of how the 2008 meltdown could have occurred in such a highly monitored environment. They, and almost all others, missed the "unknown unknown" risks of US house price falls triggering first a collapse of US financial institutions and then a European government debt crisis.
The absence of short-term "unknown unknown" risks is the reason why early 2014 markets are likely to maintain their upward momentum, running away from their fundamental valuations. Eventually, however, one or more of the "unknown known" risks is likely to be appreciated enough for the markets to fall back by the end of the year. So a fall of 10-15 per cent in 2014 is entirely possible, encouraging champagne-popping naysayers - but only after a healthy first-half rise.
Richard Harris is chief executive of Port Shelter Investment Management