Where should you put your money in 2014?

Everyone who invested in the stock market made money last year. It was almost impossible not to. US equities rose. UK equities rose. European equities rose. Even Japanese equities—which pretty much everyone in the market had long given up on—rose. If you held a bog standard portfolio of developed market equities you would have had to do something deeply dumb to end up making less than 20 per cent on the year. That was nice.

Will the same happen this year? It’s almost impossible to find anyone who thinks it won’t. Ask an analyst and he or she will tell you one of two things. The first is that markets will rise because economies are improving: the crisis is over. The second is that ongoing quantitative easing (the process whereby central banks print money and pump it into the economy) and super low interest rates will keep pushing markets upwards indefinitely.

The first is nonsense. There is absolutely no correlation and never has been between economic growth and stock market returns. Markets are moved by money flows in the short term and valuations in the longer term. Whether the financial crisis is over or not is entirely by the by (although for the record it is worth saying that it is far from over).

The second point is clearly more valid given that it focuses on money flows. The key here is understanding quantitative easing and how it works to boost the price of all assets. When the Bank of England, the Federal Reserve or the Bank of Japan indulge in what governments like to call “unconventional monetary policy” and the rest of us like to call “printing money,” they use new money to buy bonds in the market. The person who sold them the bonds now has the money. They use it to buy something else, perhaps some shares in Spain. The former holder of the Spanish shares then uses the cash derived from this sale to buy something else, perhaps a little bolt hole just off the King’s Road. Just in case. The money jumps like a hot potato (this is an analogy I have borrowed from Peter Warburton of Economic Perspectives, the economic consultancy) from one asset class to the next pushing up demand and hence prices on every stop.

Anyone in any doubt about this need only look at a chart showing the expansion of the Federal Reserve’s balance sheet (as it has created all that new money) and compare it with one showing the rise in the S&P 500 over the last few years. Rarely have two lines moved in such harmony. If that’s not enough you can turn to a fascinating chart published in the Bank of England Quarterly Review back in 2011. This shows just what the Bank expected quantitative easing to achieve. There was to be an “impact phase” during the actual money printing when the Bank assumed that nominal GDP and inflation would both rise a bit but that asset prices would soar (this is exactly what has happened). Then there would be an adjustment phase post printing, when asset prices would fall back to roughly where they started in inflation adjusted terms. The point is not just that QE has been the key driver behind rising asset prices but that the world’s central bankers knew that this would happen.

So what does all this tell us about where to put our money now? Two things. First, if you are investing for the long term ignore the money flows and look for markets that are cheap in valuation terms. Russia, which is currently one of the cheapest markets in the world, works well for this. And second if you are a little more short term in your thinking buy into markets in countries with central banks firmly in the impact phase of QE. The obvious one is Japan: the Bank of Japan has promised to print until it has at least doubled the monetary base in Japan. That’s enough to get an awful lot of hot potatoes bouncing around its market.

Merryn Somerset Webb is Editor-in-Chief of Moneyweek