Markets remain upbeat despite prophecies of doom

Serious Money Chris JohnsFew people are surprised these days by the ever increasing number of instruments that can be traded across financial markets, or the increasing complexity of investment opportunities open to the ordinary investor and institutional big gun alike.

A cursory glance at one of the many online betting shops will usually discover a financial section and a wide variety of gambling opportunities. The explosion in markets for "derivatives" is usually behind a lot of the new opportunities.

At the start of any business day, we can have a simple bet. For example, on whether the FTSE 100 will rise or fall on that day - or a myriad of other, slightly more sophisticated, wagers.

Market practitioners like to look at the behaviour of derivatives for a number of reasons. It is always important to know what is priced into any asset, and derivatives can often provide important clues. If a high price-to-earnings ratio for a company is an old-fashioned way of asking what sort of future is priced into the stock, the modern way is to look at the behaviour of option prices, and their characteristics, to make all sorts of inferences.

One of the things that we look at very closely is the underlying "volatility" of the security in question.

We can work out if the market is expecting a stock price to move a lot, or very little. This is not necessarily an expectation about whether something is going to move up or down in price, but whether it is going to move at all and by how much.

There are plenty of ways to make bets purely in volatility terms. If we believe the market is pricing in too much or too little likely movement in the stock price, we can bet accordingly. When volatility is too low for example, we can buy it, in the expectation that its price will rise when the market is surprised by how volatile the stock's share price is in reality.

Another way to think about this is to substitute the term "volatility" with the word "risk". If markets think the world is a particularly risky place, or that it is about to become so, we can gauge this by measures of underlying/expected volatility.

Think about the market environment right now. Analysts are obsessed with ever rising oil prices, global terrorism, clashes of civilisations, rising US interest rates, unprecedented global financial imbalances, growing US protectionism, the rise of China as a superpower, a possible fall of the House of Saud and Italy spinning out of the euro to name just a few of the usual suspects occupying the minds of doom merchants.

While it is obvious that something must be going right - equities are close to four- year highs in many markets and interest rates are generally low and well-behaved. We might be forgiven for thinking that when we look at how markets are expecting asset prices to move over the next year or so, we will find that the answer is "quite a lot".

We may not know whether it is up or down or both. But we would expect - given our list of concerns, all of which cause market volatility - guesses about the future to include some insurance for movement in asset prices. Somebody somewhere is surely betting that we live in risky times. Not a bit of it. Volatility across a lot of asset classes, not just in stocks, is close to historic lows.

Markets are signalling, in more ways than one, that the world is as free of risk as it has been in living memory. What is going on?

Harvard history professor Niall Ferguson has recently taken a look at this question and asked if there are any lessons that can be drawn from similar periods in the past. He is not the first to remark that the global environment is eerily similar to the one that prevailed in the decades running up to the outbreak of the first World War in 1914.

Indeed, globalisation is often described as a phenomenon that started with the Industrial Revolution (or earlier) and was merely interrupted by the emergence of communism in the 20th century.

Prof Ferguson tells us, amazingly, that markets in 1914 did not begin to even flirt with the idea of war until two weeks before it started. It is a puzzle to this day that something that appears obvious in hindsight should have affected asset prices so little.

The parallels with today are obvious. Prof Ferguson's favourite candidate for military conflict is the situation concerning China and Taiwan. He sees a likelihood that just as Germany and Britain went to war over a tiny and seemingly insignificant country (Belgium), so could the US and China.

An economic parallel with those earlier times is that back then, Britain used to moan about cheap German imports taking British jobs. He doesn't say conflict is likely, but merely possible. For anyone who thinks such notions are ludicrous, there are still the more familiar reasons to be gloomy listed above. Given all of this, why are markets so blithely unconcerned? In fact, extremely unconcerned.

One answer is that markets are rationally focusing on reasons to be cheerful: the existence of the UN, better managed economies; lessons learned from the past; or it could be that markets are just getting it wrong.

I have two thoughts about all of this. First, there is an old cliche about bull markets in equities climbing a wall of worry. Share prices often rise when we are most worried about something and boy, does Prof Ferguson want us to be worried. Second, a technical point: when markets can assign a probability to something, large or small, they immediately incorporate that information into asset prices.

When something cannot be assigned a probability because we just don't have the information or ability to do so, markets rationally ignore this potential event and the things that the pessimists harp on about are impossible to quantify in terms of risk. Keynes discussed the difference between risk and uncertainty and our ability to price one but not the other in the 1930s.

The financial world might end because of the US current account deficit and the world itself may yet end in nuclear conflagration, but nobody I know has the faintest idea how to price either of these possible outcomes. So we don't price them. It's the derivatives market's way of saying don't worry, be happy - and those markets are telling us to be extremely happy right now.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.