Beware of the trend – it won't last forever

As investors, we all have an inbuilt tendency to extrapolate the past into the future, assuming cyclical trends will go on for ever. This is a big mistake, says Merryn Somerset Webb.

Back in July I wrote an article suggesting readers sell their luxury goods stocks.

It seemed straightforward: I could see no way that China's economy could continue to grow at 8-10% a year indefinitely (it makes no sense mathematically apart from anything else); I couldn't see how China could spend much more on stimulus than it already had; the property bubble was also looking increasingly likely to meet the usual nasty end; and if the massive money-go-round began to slow, surely the amount being spent on bling would at least stop rising.

But even as I sent the piece off I felt a tinge of doubt. The luxury sector goods sector has been remarkably resilient - since the onset of the financial crisis, sales of all things ostentatious have soared. Along the way, almost all the luxury sceptics have been converted into buyers.

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Still, while regular readers will know I'm often a little early with my investment recommendations (Japan...) on this occasion I appear to have been right. Last week, Burberry (whose shares were rated at over 20 times earnings) shocked the market with a warning of falling sales growth, and saw its shares fall 18% in a day.

At the same time there is a new trend appearing that I suspect will hit luxury goods sales over the medium term regardless of growth. It is a rising domestic anger at the ostentatious wealth displays of Chinese bureaucrats.

You can take your pick of anecdotal evidence for this, but the story of Shaanxi bureaucrat Yang Dacai sums it up nicely. Dacai appears to have irritated people by being snapped smiling at the scene of a nasty bus crash. He then found himself the subject of a blogger effort to list and price every expensive piece of kit he has ever been photographed wearing (he turns out to have a penchant for designer watches). He is now being investigated. If I were a bureaucrat in China and in the habit of buying and gifting luxury goods, I think I might consider this a good time to go cold turkey.

There's a reminder here for investors: we all have an inbuilt tendency to extrapolate the past into the future. We look at cyclical trends and, once they have gone on for a while, we turn them into linear trends in our minds. This is how we make our biggest mistakes.

So, in the early 1870s, investors assumed that railway stocks would rise for ever; in the 1960s they assumed the 'Nifty Fifty' would outperform for ever regardless of price. Back in 1999 everyone assumed the gold price would drift down forever; in 2006 that US house prices would rise for ever; and until only a matter of months ago that China would keep its GDP growing at four times the rate of the US for decades to come.

None of these things happened. But the assumption that they would has created a whole lot of bubbles and crashes.

So what trends might we be over-extrapolating at the moment? There's Japan (extrapolated as rubbish forever); there's gilts and treasuries (they've been in a bull market for 25 years, so they'll stay in one); there's still Chinese growth (the bulls aren't giving up so easily); there is the outperformance of dividend-paying stocks with predictable earnings; and there is Apple.

Finally, there is Europe. Look at the net inflows into equities since 2008 and you will see that money is mostly still heading for the US and for emerging markets. It is heading out of Europe at speed. Europe has looked so bad for so long, one fund manager told me this week, that it has become "almost a badge of pride" for managers to say they have no exposure to it. That's despite the fact that the euro area is on the lowest price/earnings (p/e) ratio globally (just under ten times) and that, in these times in which everyone insists their main focus is yield, it offers the highest nominal dividend yield (4.6%).

It isn't really possible to talk about investing this week without mentioning quantitative easing (QE). The details of last week's action have been extensively covered elsewhere. But QE always works the same way on markets. Sell a bond (or anything else) to a central bank and you have cash, which you can use to buy another bond, perhaps from someone who uses the money to buy a gold mining share, perhaps from someone who puts it into a China fund, which he buys from someone who then buys a precious metals ETF. However it moves, the money acts like a hot potato leaping from player to player and sprinkling a little bubble dust on each asset as it passes. Look at it like this and it is clear that any QE is a buy signal.

But if you are going to be in the market for a bad reason (the existence of QE is no longer a good thing) you might as well hedge yourself by being in it for a good reason too. To my mind, that means buying markets that everyone else is extrapolating in the wrong direction.

The world's fund managers as a whole are famous for their 'buy high, sell low' methodology. I suspect the rest of us would be better off doing it the other way around.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.