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The brain drain

Behavioural finance explains why investors feel pessimistic about equity market performance

Despite equity markets hitting new highs, not only in the UK but across the globe, surveys of investor sentiment appear to yield universally negative results.

Behavioural finance tells us that faced with complex decisions, the human brain often takes short cuts to arrive at an estimate of the answer without digesting all available information. Psychologists refer to this as the availability heuristic, meaning that humans are far more likely to base decisions on what they can remember rather than the complete set of relevant data. One example is the tendency of the brain to give greater credence to recent events ahead of inform-ation from further back when determining a logical outcome. Given the experience of most investors over the last 10 years, it is not sur-prising that they expect a pullback in the market. But is this borne out by the fundamentals?

The obvious place to start is valuations. Relative to historical levels, particularly in relation to bonds, equities look attractive. The bears would counter that this is all based on overly optimistic profit projections. Corporate profitability as a percentage of GDP is at historical highs and at a level generally associated with the peak in equity markets. In the past, profit margins have declined from this level as labour has increased its share of GDP at the expense of companies.

We believe that the threat of outsourcing – the increasing integration of China and India into the global economy adds around one billion extra workers to the global labour pool – is such that the ongoing upswing in economic growth will feed into corporate profitability as productivity continues to improve. In our regular conversations with corporate management, they frequently comment on how they have rarely had it so good. All this leads us to believe that the outlook for corporate profitability remains intact.

There is always the risk that the growth of the global economy slows significantly, pressuring corporate profits. The most often cited source of such decelerating growth is a housing-led slowdown in the US. The argument is that a heavily indebted US consumer has only been able to sustain spending by withdrawing wealth from their property. This is only sustainable while housing prices continue on their upward trajectory. There is some merit in this argument but other Anglo-Saxon economies, including the UK, have undergone a similar dynamic without a collapse in their economy.

Unquestionably, these economies benefited from the tailwind of a strong US economy to cushion some of the slowdown but the magnitude of the rise in US property, despite all the press comment, has been significantly lower than in the UK, giving some confidence that the correction will be mild. Consensus forecasts for the US suggest that the economy will slow to around 2 per cent per cent growth in 2007 – a level that most major European economies would be delighted with.

If the current level of profitability is broadly sustained over the medium term, the upturn in merger and acquisition activity is likely to continue. Company balance sheets have been repaired and management are again looking towards growth after a period of retrenchment. Perhaps more important for equity markets, the ongoing appetite from financial buyers such as private equity shows no sign of abating. With corporate bond yields at multi-year lows, financial buyers continue to generate handsome returns by arbitraging high-cost equity for low-cost debt. Perhaps the greatest risk to equity markets in the absence of any significant macroeconomic shock is that there is a substantial increase in credit spreads, which lowers the attractiveness of this particular debt-for-equity swap.

I believe the next 12 months will be rewarding for equity investors. Unfortunately, behavioural finance suggests that individuals, particularly males, display overconfidence. And numerous empirical studies have demonstrated that investors are overconfident in their ability to forecast the future.

Neil Veitch is manager of the SVM UK opportunities fund


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