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Where Will Markets Go Next? Follow the Fund Flows

I don’t know if there’s ever a time when it’s obvious where the market is going in the next few years, but this time seems particularly difficult. The current situation has stocks that are slightly or moderately above fair value, and bonds (both short and medium-term) with very low yields. At this point you would expect there would be pressure for interest rates to rise and for stocks to possibly start drifting lower. And if you read the news you could switch your position every day. Are we headed for a crash, or will markets keep defying gravity for a while longer? Is cash a good stabilizer or a lost opportunity?

The key, as always, will be fund flows. Investment markets don’t gently move to the ideal price and then stay there. Instead they swing back and forth between extremes, driven by investors who are chasing the hot performers and bailing out on anything that’s falling. The best decision is the one that gets you ahead of other investors. In thinking through the current situation, I came up with 3 pressures that are affecting today’s market:

  • Many investors, fearing risk, have switched to the safest investments they can to avoid losing capital. This has driven up bond prices.
  • Others who need income have abandoned low yielding bonds to seek out alternatives. This has driven up stock prices (and seems contradictory to the first point).
  • Many investors are likely still afraid to move and sitting on cash, waiting to deploy it. Some have good reasons (waiting for prices to fall) while many likely have bad reasons (waiting for prices to advance further). Others aren’t consciously sitting on cash but will be sucked in once we haveĀ  “no-lose stock market”. This could lead to stock price rises in the future.

And there are 3 important factors that will play out in the future:

  • Interest rates will rise, in different ways at different times. This will hurt bond prices but lead to higher demand.
  • Investor confidence could go either way, since it is sensitive to the smallest unpredictable things. It doesn’t seem to be close to previous peaks yet and has been moving up, so the trend could continue.
  • Fundamentals are likely to improve, but may get worse. These operate at the individual level (employment leads to investment) and the collective level (don’t expect heavy government spending). Despite the bad news, there is growing demand in emerging economies that may drag along the rest of the world (but who knows what’s really happening in China?). This may drive inflation in slower-growing economies.

Of these factors, my expectation for the most likely scenario is that interest rates rising are a near certainty, investor confidence tends to follow the trend but could reverse any time, and fundamentals will move very slowly and may only have an impact over 10-20 years. So the next few years could go something like this:

  • Central bank rates rise. This has an impact on medium-term bonds, but every time their yield goes up, some investors who need safe income come back to bonds and contain the price increase (in Canada, 5-10yr yields have apparently fallen over the last year). Medium-term bond yields could stay low for some time but might rise fairly quickly once the short-term pressures run out.
  • Investor confidence grows as they get bored with macroeconomic drama, leading scared investors to move out of bonds and into more risky investments (the bond market is huge so it probably won’t crash because of this). This could easily push stocks and other alternative investments higher.
  • Growing confidence moves cash into investments, more on the risky side than in fixed-income.
  • Stabilizing fundamentals could lead to rises in exports from China & co, giving them more cash to invest in US Treasuries, buy up companies in developed countries, and inflate their own economies.

Despite all the negative news, there is a story that supports some further growth both in safer and riskier investments. Will this happen, or will the curse of the forecaster strike and make me 5 years early? Let’s hope bond yields start seriously rising in 18 months, with the stock market peaking a year later and allowing me to move some profits to safety and higher yields!

Conclusion: despite the drama in the news, there are a lot of opposing forces being ignored and it’s not time for any dramatic moves.

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