Secrets Of Success: Quick recovery? Only if policy-makers wake up

April's rally in the stock market has been a reasonable one, and the final outcome for the year may well prove to be better still, as I suggested a few weeks ago. But the evidence so far is not yet conclusive that we are out of bear market territory. You only have to look back at a chart of the Japanese stock market since 1989 to see how protracted bear markets are often punctuated by what look like powerful rallies, but which are unsustainable. The Japanese stock market, for example, returned more than 80 per cent in a year just a few years ago, and seems to do something similar every four years or so, though the underlying downward trend has been unmistakeable. In times like these, you need to perform a careful balancing act between wariness on the one hand and leaving yourself open to a pleasant surprise on the other.

While I am no economic pundit – and have a healthy scepticism for the breed – it is not difficult to spot a good one when I meet one. I have been pondering some interesting things that Andrew Smithers had to say when I interviewed him the other day. As an independent adviser to the fund management industry, Andrew passes most of my tests for a worthwhile pundit. He is always stimulating, is prodigiously knowledgeable and opinionated, and produces material that professional investors are happy to pay for (as opposed to punditry that is effectively given away for free by banks or investment houses as an incentive to trade).

He has also been spectacularly right about most of the trends in the economy and stock market over the past three years, which helps to inspire confidence, though it is by no means a necessary condition, one has to say, for success in the punditry game. In general terms, Andrew takes a somewhat jaundiced view of the quality of economic policy-makers, and particularly so in the case of the Japanese and European central banks, who are the butt of many of his best jokes.

His view now is that policy-makers are, in general, still behind the game. The UK economy is clearly slowing down, he says, and is set to continue doing so, whatever Gordon Brown might like to assure us to the contrary. (I have learnt from my own experience that monitoring what is happening to retail and office space down the street is a fairly reliable guide to the state of the local economy. Where I live, estate agents' boards are beginning to proliferate as shops that have survived on wafer-thin margins disappear, despite record low interest rates.)

In fact, the world economy as a whole is also sluggish, operating below capacity and growing below its long-term trend rate, according to Smithers. In these circumstances, you would normally expect the monetary authorities to provide a powerful corrective stimulus. Yet, except at the margin in the United States, this is not really happening, which implies that next year may also be no great shakes for the world economy.

In fact, Andrew's thesis is that the reason that even the Federal Reserve, which is the most clued up of all the world's central banks, is not yet doing enough to stimulate the economy is that it finds itself in an awkward bind brought about by its inability or reluctance to acknowledge its past errors. Having correctly identified the prospect of a bubble in his famous "irrational exuberance" speech in 1996, the Fed chairman, Alan Greenspan, signally failed to do anything about it subsequently, preferring instead to hide behind the argument that controlling asset bubbles before they had run their course was in practice next to impossible.

This, according to Smithers, was a serious policy error, which is now being compounded by risky inertia. With investment still to recover from the investment-led boom of the late 1990s, and the savings ratio at very low levels in historical terms, it means that the onus must be on fiscal policy to redeem the situation for the US economy. While the Republican tax cut of two years ago has been helpful (albeit introduced for a quite different reason), more is needed but does not yet seem to be forthcoming.

What we need, says Smithers, is an old-fashioned bout of demand stimulus, which is a problem when the Republicans do not believe in it as a concept. If only to get re-elected where his father did not, President Bush is likely to give the US economy a huge push by the autumn at the latest, but it may be too late to avoid trouble when the risks of deflation and severe recession remain a live possibility. In Europe, the prospect of a stimulus programme is more remote still, underlining what Andrew calls the "unwritten law that anyone with an understanding of macro-economics must be banned from public office in Europe".

What conclusions should one draw from these trends? Andrew's view is that the American stock market remains at least 30 per cent overvalued, and nowhere else looks particularly cheap. There is also the risk of a big chunk of new shares coming onto the market, as more companies take the opportunity of any recovery in share prices to try to repair their ravaged balance sheets. The fact that the yield on shares now looks relatively attractive compared to that on bonds tells you only that bonds look expensive, not necessarily that equities are too cheap.

So while government bonds may do well in the short term as the economy weakens, in the longer run they are liable to be fraught with risk. However, says Smithers: "The risk of deflation in Europe is worse than it is in the UK, so if you are going to go for bonds, you should go for European bonds."

In the UK, his advice is that manufacturing and industrial stocks are likely to fare better in relative terms than the banks and financial sector as sterling continues to weaken. The bottom line is that investors' expectations of a quick recovery are likely to be dashed unless the policy-makers get their act together.

davisbiz@aol.com