The Hindu Business Line : Take stock of the markets

Do stock markets lead or follow the business cycle trend? “They lead it,” assert Deborah Owen and Robin Griffiths, authors of Mapping the Markets ( www.vivagroupindia.com). “Markets sometimes discount things that then do not occur. ‘The stock market discounted all nine of the last five recessions,’ said Paul Samuelson, the Nobel laureate economist,” they add.

Owen is managing director of Investment Research of Cambridge ( www.irc100.com ), London, founded in 1945, which specialises in technically-based research. Griffiths, who has worked in the financial markets since 1964, is currently head of global investment strategy at UK-based Rathbones ( www.rathbones.com), ‘established 1742’. Their book seeks to bridge the gap between technical and fundamental analyses. Excerpts from an e-mail interview.

Do the economic and business cycles help in interpreting and understanding the stock market movement in the longer run?

Yes. When the economic and business cycles are in a secular uptrend, it will exert an upward bias on the stock market. Rallies will be very strong impulsive moves while corrections will be relatively mild and may even just be consolidations before another wave of buying takes the market higher again. The converse happens when the longer-term cycles show a secular downtrend.

In the stock market, normally, would stock prices of companies in a segment reflect their business cycles?

Yes. For example, when the stock market is at the low point of the cycle, the economy will tend to be weak and expected to get worse. There will be a perception that interest rates will have to fall and, on the back of this expectation, interest-rate sensitive stocks will start to perform better.

What are the factors that link the economy with the stock market?

Macro forces such as money supply and interest rates. The rating of earnings, the share of profits as a ratio of GDP and, finally, structural factors can distort the correlation between development in the economy and the stock market. Until fairly recently, China’s very strong GDP growth was not reflected in the performance of the domestic stock markets due to these ‘structural’ factors.

Recessions can occur due to excessive and irregular policy adjustments. What are the other aspects that can also result in recession in an economy?

Downturns in the business cycles and ‘external’ economic shocks. If bird flu were to mutate to humans and result in an epidemic, it would be an external shock, for example.

Industrialisation and demographics are two powerful economic forces that can spur secular growth. How much is that statement relevant with globalisation becoming a reality today?

A lot. Financial markets are reflecting the long-term secular trends. The huge amount of liquidity in the global markets is a result of the enormous surpluses that China and other Asian central banks are running. This liquidity has helped keep long-term yields low. And cheap debt has been fuelling the record number of merger and acquisitions deals that we have seen over the past 12 months.

The growing economic strength of countries such as India and China has also brought a new source of funds in the mainstream stock markets. Indian companies have been particularly active in this respect. The Indian conglomerate, Tata, for example won a bidding battle against a Brazilian company for the UK company, Corus Steel. China has been slightly slower off the mark but recently the authorities placed $3 billion with Blackstone, the US private equity group.

Do stock markets in the US follow a ‘four-year cycle’? What about the other global markets?

Broadly yes, but there is sometimes a lag between the US and other markets. As the US is the largest economy at present it exports its cycle to others in the global economy. The one notable exception is Japan. And we explain the reasons for this in our book.

How does stock selection based on ‘fundamentals’ differ from stock selection based on technical analysis?

In our book we have tried to show that the divide between technical and fundamental analysis is not as large as most people tend to think it is. Fundamental analysts are trying to identify undervalued assets while technical analysts are looking for stocks where the share price is showing upward momentum. Most of the time — but not always — these stocks will tend to be growth companies.

In the long run, technical analysis is essentially a visual representation of the economic process of creative destruction.

What is the best way to choose a stock, following the trend or its relative strength against the index?

We like to see the trend line supported by relative line.

How true is the adage ‘Sell in May and go away’? Do business cycles have any link to that statement?

The early summer months are historically a vulnerable period for stock markets. But this is not to say that there will be correction every year at this time. As far as seasonal trends are concerned, the stock market is rather like the Atlantic hurricane season. Damaging hurricanes don’t happen every year but if they do occur, they tend to do so during the hurricane season. We have back tested the data on forty world markets and they all have the same seasonal deviation. The one exception is New Zealand. The average drop due to this factor is about 9 per cent but if the long-term trend is rising faster than that, then it will appear that the seasonal move did not work.

Economists say that expansion normally takes place if entrepreneurs try out new ‘innovations’ for commercial launch when economic conditions are favourable. What are those conditions?

Flexible labour and capital markets. For instance, the European structural rigidities in the 1990s impeded the development of technology and biotech companies.

What are the important lessons an investor should learn from ‘Bursts’ in the history of global market, whether in the US, Japan or any other market? What are the precautions an investor should take to insulate himself from this?

All bubbles look similar. They go on longer and rise further than most people think possible. “The market can remain irrational far longer than we can remain solvent,” John Maynard Keynes had said. They end with an exponential surge where more money is made quicker than ever before, and to protect themselves against the inevitable burst investors must adopt a rigorous stop-loss policy.

In your opinion, where is the US market heading: up or down, and what is the current economic and business scenario there?

The US market is headed up for now, but its economy is cooling and it is passing the baton of leadership over to China and India. Its bull move is getting long in the tooth and it will need to at least catch its breath, probably this autumn.

How does India compare with China in the economic sense and growth? Do you foresee that capital inflows would continue to flow into India in the future with the reforms in place here?

India started to grow later than China, but has two huge advantages: it is a democracy and English is widely used. Also, its demographic status is healthier.

Businesses are increasingly exposed to overseas markets. Any marked downturn in the overseas trading partner could adversely impact the domestic market. What is that any government should do to either prevent or limit the slide?

Unlike China, the Indian economy is less exposed to a downturn overseas, especially the US. However, in the event of a downturn, the government must be prepared to take appropriate monetary and fiscal action. Capital flows should, therefore, continue to flow into India.

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