• Tue
  • Dec 23, 2014
  • Updated: 1:32pm
CommentInsight & Opinion

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

PUBLISHED : Monday, 30 December, 2013, 5:49pm
UPDATED : Tuesday, 31 December, 2013, 5:01am

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


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This article is now closed to comments

I would just like to check, is this the same Richard Harris of Port Shelter Investment Management who just over a year ago (SCMP, Sep 04, 2012 'World economies on autopilot') said that "Greece [is] likely to exit the euro before the end of the year, almost certainly followed by Portugal and Cyprus."

And the same Richard Harris who tried to coin the term 'Lionomics' in May of this year (again, SCMP), only to rebrand it again to 'Likonomics' in June?

What kind of prediction is this piece anyway?

"A single digit rise in Wall Street in 2014." So this could be anywhere from +0.1% to +9.9? Nice range. Are we talking year on year rise, or a high watermark here? And is this the DJIA, or the S&P500 Mr Harris? And do you actually predict this or not? Because a couple of paragraphs later you already hedge this prediction with talk of a "entirely possible" (is anything ever only partially possible?) 10%~15% fall in 2014.

So in summary, Mr Harris forecasts that unspecified 'stock markets' will go up 10% in 2014. Or down 10%. Or maybe up 10% first, then down again 10%. Might be a bit more too. Or less.

It is just waffle, nothing more. There is no rhyme or reason to this piece. It only contains the usual cowardly phrased, semi-intelligent sounding non-predictions that asset managers specialise in.

If Mr Harris wants to make a prediction, let him specify which index he is talking about, what level he targets and by when. Then we can tally the score next year.
The most feared of all - "unknown unknown", is perhaps the same as Nassim Nicholas Taleb's black swan, the extreme outlier.
My impression is that, many readers' comments here in the morning post are also outliers of the (more or less) normal distribution curve of public opinion --- the most important middle part of the curve remains the silent majority. Sarcasm is king (or queen).
The Efficient Market Hypothesis says that market prices incorporate all available information, making beating the market statistically unlikely.
We don't really need Robert Schiller to reject Eugene Fama --- Warren Buffet has been doing the job pretty well.
That said, sometimes a blindfolded dart-throwing monkey is indeed more successful than those professional experts.
I think the always-successful formula of stock investing, which works at any time for any excuse in any way, is yet to be found.
Or a person may have found it, but it is as well guarded as Coca Cola's secret formula.
And that person is certainly the wealthiest person in the world, even beating Walmart's Walton-family-members combined.


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