Have the stock market's stars shone too brightly?

Spectacular share performances cannot continue indefinitely, writes David Prosser
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The Independent Online

But has the stock market recovered too fast since it hit rock bottom at 3,200 at the end of 2003? The pace of improvement has taken many investors - both institutional pension funds and individual savers - by surprise. The big question is whether the gains are sustainable.

Many large fund managers are upbeat, though remember that as the tax year draws to a close, they are in the midst of marketing campaigns for stock market-linked individual savings accounts (ISAs).

New Star Asset Management points to research that suggests the Footsie could hit 6,900 before the end of 2008. The analysis is based on events following the three most serious bear markets of the 20th century.

The current market recovery mirrors share price performances following those three periods. "If the forecast continues to be accurate, equities will rally sharply until mid-2007 and then be followed by a more modest period of growth," says Simon Ward, New Star's global strategist.

Leigh Harrison, head of UK retail investments at Threadneedle, is similarly positive. "The UK economic backdrop at present looks reasonably settled with interest rates likely to fall, if anything," he says. "Equities are still cheap and we are very much pro-growth."

However, not all analysts have such a rosy view. Justin Modray, of the independent financial adviser Bestinvest, warns: "While the long-term prospects for well-diversified portfolios remain reasonable, I'd be very surprised if the next three years are as favourable as the last three."

Crispin Finn, director of UK equities at Credit Suisse, says: "We expect the market to test the 6,000 level this year, but after such a strong three-year run there are signs that this bull market is maturing - momentum is rolling over in some frothy areas and some stocks are floating on very generous valuations."

Certainly, there are domestic risks. Consumer debt, for example, continues to be a major area of concern as the number of bankruptcies and repossessions rises. Britain's leading banks have all reported record profits in recent weeks; they have also all increased their bad debt provisions in the UK.

Daniel Hanbury, manager of Investec's UK Alpha Fund, says: "For all that has been written about the special effects of take-over bids, mergers, rumours and what have you, we are doing no more than rise in line with the global equity market."

Hanbury also points out that share prices have not risen uniformly - the telecoms and general retailers sectors, for example, have fallen over the past year.

The UK stock market has been able to shrug off worries such as declining consumer confidence because many of our large companies are international businesses. Global economic themes are as important to them as local concerns.

Here too, however, there are worries. Interest rates in both the US and the Eurozone have been edging higher. Serious one-off shocks to the global financial system - a bird flu epidemic, say, or a further deterioration in the west's relationship with Iran - could have an even more serious impact.

Gerard Lane, an investment strategist at Norwich Union, says investors would be wrong to ignore such risks, though he believes the general global outlook remains benign, with inflation under control across the world.

But even without a shock to the system, Lane believes a correction is possible in the near term. "We're overweight UK equities - it's the asset class of choice compared to bonds and property," he says. "On a three- to five-year outlook we're very positive, but in the shorter term, prices have risen so far in such a short space of time that we have to be wary."

Eight stocks for every eventuality

FOUR BUYS FOR BULLS

BAA: Threadneedle's Leigh Harrison says: "We look for companies with restructuring potential... BAA has a significant market position and a regulated income stream".

Kazakhmys: Investec's Daniel Hanbury says: "As a very low-cost, vertically integrated copper producer, the company has a very low cost base and high cash generation relative to its peers, with ample opportunities to reinvest."

Paragon Group: Hanbury adds: "Specialising in buy-to-let mortgages, its value looks undemanding and the shares are in a solid uptrend on the back of a still buoyant buy-to-let market."

Premier Farnell: Harrison says: "Many opportunities are under-managed but retail good growth potential, such as Premier Farnell."

FOUR BUYS FOR BEARS

BT: One common strategy for investors keen to guard against falling share prices is to look for stocks offering decent dividend payments, and BT currently yields close to 5 per cent.

Diageo: Food and drinks companies are classed as defensive shares. When times are hard, people are less likely to reduce spending on these products than luxury goods. Demand should hold up well.

Meggitt: Shares outside the top rank of the FTSE 100 have risen even more quickly over the past three years and engineering company Meggitt is no exception. The stock is a play on stable industries and should be less volatile.

Rolls-Royce: The company's business cycle is long-term insulation against short-term risk - with contracts for delivery over many years.

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