Belfast Telegraph

Risk factors at play in equity markets

Jonathan Cunningham, managing director at Cunningham Coates Stockbrokers, takes a look at how equity markets are coping as jitters creep into both the eurozone and US economies

On the back of economic events, we are becoming used to hearing on the evening news that stock markets have risen or fallen by 2% or more. Invariably, this seems to extend beyond individual national markets, with newscasters almost implying competition between markets to exhibit the widest swings: “Germany’s DAX was down 3.2%, France’s CAC fell 2.8%, while London’s FTSE 100 Index only dropped 1.9%.”

These markets, along with American markets, are now moving in parallel.

In addition, the vast majority of share prices the markets represent are also moving in unison.

This is in marked contrast to the market excesses and declines at the turn of the millennium, when technology, media and telecoms shares frequently exhibited large moves in the opposite direction to sectors such as engineering, resources, utilities, banks, etc.

In this way, significant ‘sector swings’ could cancel out when the evening market report simply stated that the London Index was relatively unchanged. Now we see screens as almost universally blue or red.

There are a number of reasons for this. Firstly, we have the concept of ‘risk on/risk off’ trading. Markets are being driven by national and even supranational issues, such as the paralysis in American politics around the debt ceiling and, of course, the sovereign debt crisis in the eurozone.

The macro-economic implications of outcomes which, until recently, would have been deemed inconceivable (a technical default by the US Government or an uncontrolled default in a Mediterranean European member of the eurozone) have become potential realities.

As a result, a single phrase from one of a dozen or so individuals or their spokespersons (Jean-Claude Trichet of the European Central Bank, Ben Bernanke of the US Federal Reserve, Christine Lagarde of the International Monetary Fund, Mervyn King of the Bank of England etc) or an announcement from a politician from Europe or beyond sends markets into a spin. Traders seem to get into a mindset resulting in an arbitrary putting of ‘risk on’ the table or taking ‘risk off’ the table.

The evolution over the past 10 years or so in the way that markets work has, however, increased the impact of this. The expansion of products which replicate markets or indices has ballooned. Exchange Traded Funds, in particular, have blossomed from almost nowhere to be valued at circa $1,600bn.

These provide an easy platform for investors to move in and out of broad baskets of assets, depending on their risk perception. In addition, derivatives markets continue to grow although they have been in existence for considerably longer than ETFs. The expansion of hedge funds using these markets has, however, expanded more dramatically. These contribute to both the greater volatility in the market and the increased correlation between markets and sectors.

It is the combination of both the above factors which have led to the current feeling that if markets aren’t broken they are, at the very least, behaving dysfunctionally. Worryingly the volatility of markets (in which there are ETFs to speculate on) as well as their direction can now influence the economic outcomes as much as provide a measure of expectations.

This does not constitute a recommendation to buy or sell investments and the value of any shares may fall as well as rise. Investments carry risk and investors may not receive back the amount invested. The views expressed are those of the author and not necessarily of Cunningham Coates Stockbrokers

Belfast Telegraph