Secrets of Success: Is the stock market overvalued today?

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The Independent Online

It pains me to say that my friend Ian Rushbrook, the independent-minded Edinburgh fund manager, is unimpressed by those who argue that there is value to be found in the equity market at current levels.

It pains me to say that my friend Ian Rushbrook, the independent-minded Edinburgh fund manager, is unimpressed by those who argue that there is value to be found in the equity market at current levels. Although the market has drifted down for most of this year, and has been becalmed for some time, it would be comforting to think equities were still undervalued after the bull market/bear market/bull market rally cycle of the last 10 years.

In Mr Rushbrook's view, alas, this just ain't so. He regrets it too, because rising markets stand to make his investors more money. They will also boost his personal income and capital, both of which largely depend on the value of Personal Assets, the investment trust he has run for wealthy private individuals since 1990.

Mr Rushbrook has an excellent record as a go-it-alone investment manager, who at his recent annual meeting gave his shareholders the benefit of a 45-minute discourse on why he thinks the stock market is currently overvalued. With market volatility at its lowest for a long time, it seems like a good moment to pass on his reasoning.

His argument on valuation starts with the interaction between inflation, earnings and dividends. If you look back over the last 40 years, the period breaks down into a number of distinct phases. From the mid 1960s to the mid 1970s, inflation was generally on an upward trend: from the inflationary peak of 1975, which coincided with the bottom of the 1974-75 bear market, the trend has been downwards, though not without significant blips along the way.

At the moment, inflation appears to be edging back up again, but while it seems clear that the great disinflationary trend of the past 20 years has come to an end, the jury is still out on whether we are about to enter a new permanent phase of either inflation or deflation. What investors need to understand more clearly, says Mr Rushbrook, is the dynamic that links inflation to earnings and market valuations.

His argument is that rising inflation acts like a headwind against improving corporate earnings, while disinflation acts as a tailwind that boosts profitability. The fall in inflation over the last 20 years from 22 per cent to 2 per cent has therefore provided a built-in, continuing boost to corporate earnings potential. When inflation is falling, the prices that companies can extract from customers tend to fall more slowly, giving them the equivalent of a strong rise in profit margins.

From a valuation perspective you can see this most clearly in the behaviour of dividends, which Mr Rushbrook regards as a much better indicator of underlying corporate performance than reported earnings, which are notoriously prone to manipulation and cyclical influences. Being paid in cash, dividends tend to give a more reliable picture of corporate prospects than earnings.

Looking back over the last 40 years, you can clearly see there is an inverse relationship between inflation, the dividend yield on the UK stock market and total returns from equities. From a peak of more than 12 per cent at the bottom of the 1974-75 bear market (when inflation was at its peak), the dividend yield fell to around 2 per cent at the height of the 2000 internet bubble, bounced back to 4 per cent in March 2003 (when the market began a strong bounce) and has since fallen back to a level of around 3.2 per cent.

The key message Mr Rushbrook derives from his analysis is that the stock market has never produced a strong performance from a point where the dividend yield falls below 3.2 per cent, while it has almost invariably been a buy when it has touched the giddy heights of 5 per cent. There have been four periods in the last 40 years when dividend yields fell below 3.2 per cent. On all four occasions the market has subsequently fallen to a new low, which was around 25 per cent lower in three cases and 67 per cent lower in the other.

Markets being what they are, the passage from dividend yield low to subsequent market low rarely goes in a straight line: in 1998-2000 the market went on rising until the dividend yield touched the previously unheard-of level of 2 per cent. You are entitled, says Mr Rushbrook, to believe that the world has changed, a new paradigm has arrived, dividends are no longer important and so on.

But he is not going to put his own money, or his fellow shareholders', at risk on such frail foundations. When the market fell to around 3,500 in March 2003, he cut back the liquidity in his fund and increased his equity exposure from a low of 40 per cent to around 75 per cent, so as to make sure he gained from any rally that ensued. Now he has been increasing the cash in his portfolio once more and says in his latest annual report: "Low inflation, coupled with real rates of return available on cash deposits, means there is now no penalty in holding cash, other than the opportunity cost of missing a temporary and ill-founded equity market rise. In this context it is surprising to hear people wondering about Warren Buffett's next big idea. Everyone seems to have missed it: liquidity, held in any currency other than the dollar".

What he is saying, in layman's language, is that the balance of probabilities now favours a period of poor medium-term performance from equities, which most likely will be triggered by a recession in the United States next year.

I think we are bound to get a period of high volatility shortly - it always comes after a period of listless, sideways-moving markets - and the nervous investor will probably take his eye off the longer-term trends as the market starts to bounce around. My guess remains that shares will still end the year higher than they are now, but in the end the long-term trends and relationships must prevail.

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