Why investors should hold onto their hats in 2018

It’s as basic as it gets, but if you look at charts of some of the world’s major stock indices… well, it’s pretty scary.

You’ll see a ‘mountain’ of a graph. Stocks in London, New York and Japan are regularly pushing all-time highs. Even here in Australia the benchmark index is sitting around a 10-year high.

What we know about financial markets is that they go up and down. They’re subject to aspects of basic human psychology like fear and greed. So, when the market rises, it can often be in dramatic fashion, and when it falls, the same applies.

Also read: Where I’d invest $10,000 today

Now that we’re close to what some fear is the summit of the current cycle, what could push markets over the top and down the other side?

Let’s take a look.

Interest rates

The discipline of “finance” can be broken down into two broad groups: debt and equity. Think of debt as bonds and equity as shares. It’s more complicated than that, but that’s fine for now.

Since the financial crisis, interest rates around the world, including Australia have been super low. From an investing point of view, it’s made sense to borrow money cheaply – with low interest rates (debt), and invest than money in the stock market (equity). It’s also made more sense to have your money in the stock market, rather then in cash/bonds, because you’ll get a higher return there.

If this dynamic changes, or is reversed, by rising interest rates, then, yes, the stock market could fall.

Many commentators in Australia don’t believe the Reserve Bank will raise interest rates any time soon, however. Some actually think rates won’t rise until 2019.

Why? Well because the Reserve Bank needs to see some evidence that low unemployment is pushing wages (and your pay packet) higher. But it’s not seeing that at the moment.

It’s hard to see higher Australian interest rates hurting the stock market this year.

Also read: Why I believe in good times ahead

Economic growth

Company balance sheets also drive the stock market.

It’s virtually impossible to group all companies together, but we can make some broad statements about Australian companies… like that many are in pretty good shape. That’s reflected in the nation’s overall economic growth.

Growth is currently sitting between 2 and 3 per cent (depending on when you take the GDP snapshot). This growth is powered by government spending, but it’s also led by consumers buying things in department stores and shopping malls, as well as business investment (all connected to Aussie stocks on the share market).

Forecasts are for Australia’s economic growth to continue north of 2 per cent. So, as long as interest rates stay as low as they are, and jobs continue to be created, the current level of corporate growth should continue, and hence the market will be supported at current levels.

Veteran UK financial markets commentator, David Buik, also sees the global economic backdrop as supportive of financial markets generally. He pins “global growth” at 3.7 per cent. Combine that with what seems to be a broad economic recovery in Europe, and you have the makings of a nice international backdrop to support the Aussie stock market.

International markets

Of course, as mentioned, international markets are looking extremely healthy. Or maybe bloated is a better description. This is where it gets a bit tricky.

You see international markets aren’t just booming, their pushing all-time record highs. That tells you we’re either in a blissful new state of permanent share price rises (hold back the laughter), or markets are overdue for a correction.

Also read: The Australian dollar looks set to test 80 cents ‘sooner rather than later’

David Buik sees overpriced markets falling somewhere between 5 and 7 per cent in the first few months of this year. He may very well be proved right. In the meantime, it’s worth noting that movements on international markets very much play a role here on the local market.

The bottom line then is to understand that a key risk for the ASX and the All Ordinaries share indices is a major fall on either the Dow Jones Industrial Average, the S&P 500, the Nikkei, or the FTSE.

Is that likely? Following the passing of Trump’s tax reform, not so much anymore. Is it possible? Absolutely. A “correction” is certainly on the cards.

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Market cycle

Another aspect of investing that you can’t escape is the ups and downs of the market cycle. In some cases, investment markets have a consistent upwards trajectory. You can see that, for instance, in many of the property markets around Australia, and, to some degree, on the share market.

For example, if you were to throw a lot of money behind both Australian property and shares over the past 50 years, you will have done quite well.

The problem is many people don’t have a 50-year time horizon, and frankly, want to make better-than-average returns over the short term. So, if that’s you, you just have to accept that, in the short term, the market, by its nature, is subject to wild swings.

X-Factor

And while we’re on the subject of wild swings, you also need to be on the lookout for ‘left field’ events. They’re market sensitive news items that can throw investors into a tailspin.

The collapse of Lehman Brothers (anticipated for those in-the-know), and the Asian Financial Crisis, are two good examples. A left field event is possible this year. Like any other event, in managing it, you need to work out whether you are in the market for the long haul, or the short run.

If you’re in for the long haul, it’s no drama. If you’re in for a quick buck, well, you’d better find the first available exit.

@DavidTaylorABC