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Suspicious minds

Few investors believe whole-heartedly in the recent rally. This is because it has been led by highly indebted oversold stocks such as banks while more defensive companies with stronger balance sheets have been left behind. Many investors now want to see actual demand pick up before deploying more of their cash into the market. As a result, they are behaving with suspicion and caution – a recognised stage in the investor psychology cycle.

The cycle is drawn as a bell curve. It shows different stages of investor feeling at different moments in the market cycle. It progresses from contempt at the bottom of the curve, through to doubt, caution, confidence, enthusiasm and conviction on the way up. It then peaks at greed and starts falling, travelling through indifference, dismissal, denial, fear, panic, capitulation and back to contempt.

Last autumn, investors entered a state of fear and panic when Lehman Brothers collapsed and the global banking system threatened to follow suit. This carried into December as the financial crisis took its toll on the global economy. Markets began to slide again in January and February as fear and panic increased but, in our opinion, they did not reach full capitulation and investors did not display absolute contempt for shares.

Instead, sentiment improved on the back of better than expected, if still bad, economic data, for example, higher numbers for housing start figures and consumption in the US. The cycle moved directly to the period of caution and doubt in which we now find ourselves, bypassing capitulation and contempt.

One idea we think worth considering suggests this is another rally in a longer bear market which began in 2000 when the dotcom bubble burst. Put forward by Russell Napier of CLSA, this idea says that instead of looking at index levels or valuations to try to determine where shares will go next, investors should instead consider inflation.

Equities tend to perform best when deflation ends and inflation returns. We may well see equities continue to rebound from March lows until inflation reaches about 4 per cent and long-term Government bond yields rise to between 5 per cent and 6.5 per cent. This would then trigger the final leg down in this bear market, ending with full capitulation and contempt. In 1968, 1973, 1987, 2000 and 2007, inflation breaching the 4 per cent level was followed by a strong correction in equity prices.

Forecasting when is very difficult, made more so by the effect of quantitative easing. QE and big economic stimulus packages ultimately may well be highly inflationary, useful for governments seeking to reduce the value of their debts. Given the weak economic data, this could take a year or two to emerge. In that time, there are likely to be additional positives for global equities, such as the US housing market finding a floor and a recovery in company earnings. Emerging markets with low sovereign and household debt and strong domestic growth should also continue to present attractive opportunities for equity investors while inflation remains at benign levels.

John Chatfeild-Roberts is head of the Jupiter Independent Funds team


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