Outlook for Equities: S&P 500

by George Hatjoullis


A story told to me by a friend seems very appropriate. He went for an interview with a famous hedge fund manager and was asked how much he had ever made trading the S&P 500 futures. He replied candidly he had never made money trading this derivative. He was offered the job. Apparently no one that claims to have made money trading this contract has ever been offered a job with this hedge fund. No doubt an apocryphal story but one that makes a very pertinent point. Trading the S&P 500 is a challenging pastime, whether professionally or as a spread betting pastime. Of course, investing in this index can be very profitable.

The above chart (courtesy of IG Index) illustrates the problem. There have been 5 distinct trends since 1997; three bull and two bear. If you had bought or sold and held you would have made out like bandit. However, we are all blessed with 20-20 hindsight and ‘holding’ throughout each trend was never quite as comfortable as it seems in retrospect. The real issue is where does this index go next?

The index has made very marginally new highs. However, there is a deep suspicion that it will reverse the recent bull trend and head to the bottom of the range. This is understandable. The world is busy trying to deleverage and everywhere there are economic crises and problems. Global growth is not exactly vibrant and the IMF is widely reported as warning of the dire risks that remain. In fact the opening paragraph of the IMF’s own comment on its just published Global Financial Stability Report states;

The global financial system is far more stable than it was six months ago, but a number of challenges remain. The International Monetary Fund’s latest Global Financial Stability Report says that recent rallies in financial markets will not be sustained, and new risks are likely to emerge, unless policymakers address key vulnerabilities. [http://bit.ly/XHMa51]

The global economic situation is in fact better but of course it could deteriorate if policy makers neglect their functions. The problem with the competence and political will of policy makers almost always applies and the system is always vulnerable to something. So I am inclined to focus on the assertion that the situation is better. Moreover, given the experience of policy makers since 1997, I am also inclined to believe that they will act appropriately, at least in the immediate future. Surely even policy makers learn? If things are getting better and policy makers do what is necessary then the context for the S&P 500 is encouraging.

In other respects the context is already encouraging. Equity indices are rightly deemed to be forward-looking and appear as components in leading indicator series. This creates something of a cumulatively positive momentum with higher equity prices seemingly encouraging higher equity prices. This sounds like an indian rope trick but all it really indicates is that if you have a positive trend you should stay invested until this trend is clearly broken. This is a uncontentious observation that some charge quite a lot to impart. In part, the latent nervousness comes form the pattern of the chart. If the S&P 500 had accrued in a straight line from 1997 to the present few would have had trouble visualising an extension of this trend. One only has to look at the gold price and note how many were happy to buy it above 1700!

The strongest factor in favour of equities, however, is that investors do not appear to be as heavily exposed as they might be. This is partly structural as changes to pension fund regulation has changed the behaviour of pension funds and these now hold lower equity weighting. However, it also partly has to do with history and the poor performance of equities relative to other asset classes over the last decade. There is plenty of room for an asset allocation switch in favour of equities.

The question is; what will trigger an asset allocation switch? My conclusion is that it will be simply the passage of time. Investors are crisis weary and have concluded that, despite the ‘key vulnerabilities’, the sky is not falling. Indicators of anxiety such as oil and  gold are adjusting downwards and in the adjustment also bring positive economic benefits. The longer the S&P 500 index holds at around the previous high levels then the greater the likelihood that it will push on and start to grind higher again. This is not to say that there may not be sharp price moves lower and media headlines proclaiming the sky is falling. This is precisely why trading the S&P 500 is so difficult.

The question that arises is; if you do not invest at least some of your portfolio in equities, then what do you invest in?