Secrets of Success: Bull? Bear? More like a hippopotamus

Inflation or deflation, economic strength or depression, stockmarket bull or bear, house-price boom or crash. Investors and observers are drowned in a sea of information and contradictory opinions.

Inflation or deflation, economic strength or depression, stockmarket bull or bear, house-price boom or crash. Investors and observers are drowned in a sea of information and contradictory opinions. The world today feels more uncertain and insecure than ever, yet most major stockmarkets are demonstrating less volatility than in the past.

Like everyone else I would love to know what the future holds. I am, unfortunately, unable to predict it with consistent accuracy, although the fact that other "experts" are unable to perform much better is reassuring. All I can do, as someone who has worked in the fund management industry for over 20 years, is to try to determine the future direction of markets, and the risks and rewards that may lie ahead, by analysing the various economic and investment indicators available. I am not in possession of a crystal ball, however, so if you want a 100 per cent guarantee, stop reading now.

To arrive at some diagnosis of current investment conditions, a brief review of the past can be useful. Mark Twain's epigram "History doesn't repeat itself but it does rhyme" is worth remembering when scanning the investment tea-leaves. The great bull market in the Eighties and Nineties, which ended (in the UK) almost on the last day of the Millennium, is unlikely to return for some time. This phenomenal rise in share prices was driven by the fall in inflation, and therefore interest rates, led by the United States and the then chairman of the Federal Reserve, Paul Volcker.

Economic growth during these 20 years was good, and investor confidence rose as a result, which in turn led to a great expansion in price earnings ratios. This culminated in the final "blow-off" in the first quarter of 2000 when Nasdaq (the index that measures technology companies) peaked at 5,049 on 10 March 2000. This rise, in its last stage, was partly fuelled by the liquidity made available to cope with the "Y2K" challenge that, in the end, passed without serious incident.

In the three years to 8 March 2003, most major markets fell by about 50 per cent (the Nasdaq by 80 per cent) as the excesses in share prices were eliminated and investors sought safety of fixed-interest investments such as bonds. Share markets have recovered since March last year but are still adrift of their historical highs.

In recent months, the global stock market rally has lost its momentum. Investors have started to worry about the effect rising interest rates will have on corporate profits growth. Sharp gains in oil prices, continued tension in Iraq and the run-up to the presidential election in the US have also played a key role in dulling sentiment.

The question for all market-watchers is whether this is just a short-term setback or an indication that we are about to return to the bad days. Or could it be that stock-market indices just do nothing?

I take the latter view. Whether one likes it or not, the prospects for the global economy and stock markets will be driven largely by events in the US. Buoyant consumer spending, fuelled by a combination of tax cuts, low interest rates and increased borrowing, has kept the US economy growing over the past few years. But looking forward, rising interest rates and anaemic employment growth are likely to dull the appetites of debt-laden US citizens. Regardless of whether a Democrat or Republican becomes US President in November, some tough choices may have to be made which could result in a choppy year for both the US economy and stockmarket in 2005.

High levels of debt owed by Anglo-Saxon consumers and deficit-ridden governments will restrain fiscal demand. This factor, combined with ageing populations in Europe, will further add to deflationary forces in the medium term. If global trade continues to grow, assisted by technological advances, pricing power among companies should be limited. Recent rises in commodity prices, especially oil, will only be inflationary if increases in money supply lead to a general rise in price levels.

The good news is that the interest rate rises needed to quell any material threats in inflation should be limited as economic growth going forward will be sluggish. In this environment of lower economic expansion, investors should be prepared for slower growth in corporate profits. This, together with the high valuations that still exist in the US market, will act as a restraint on share prices.

On a more positive note, low interest rates should underpin equity valuations. So, as William Kay correctly predicted a year ago, markets could behave like a hippopotamus wallowing in mud with investors getting over-excited as the markets head towards the top of their range and over-depressed when they head towards the bottom.

But sideways markets are not necessarily bad news for investors. The trick is to spot opportunities before others and, of course, identify stocks that will not deliver. So, while overall, stockmarkets may not return more than 5-7 per cent pa on average over the next five years, there will be chances for astute stock-pickers to make better relative and absolute gains.

In my view, investors should continue to hold a diversified portfolio of shares, bonds and cash, and invest in shares with a medium-term time horizon.

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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