Secrets Of Success: The market's rising, but where is the gloom?

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The Independent Online

The biggest challenge to the prospect of a sustained new bull market is probably now the simple fact that there are now far too many bulls around.

The biggest challenge to the prospect of a sustained new bull market is probably now the simple fact that there are now far too many bulls around.

Although you can make a good case for thinking that the lows we saw in the run-up to the Iraq war marked some kind of turning point, it would frankly be more encouraging if there was still more gloom and doom around.

Most severe bear markets do not end until there are some real signs of capitulation by investors, typically reflecting a belief that shares might never be worth buying again. While there was undoubtedly a lot of pessimism in the spring, it is disconcerting how quickly prevailing opinion has switched back to a condition of more universal optimism.

If this was a genuine new bull market in the making, this should not be happening.

A regular survey of professional opinion in the United States shows that in June only 20 per cent of fund managers were still bears, which is one of the lowest readings for at least a decade. For individual investors, the proportion of bears is even lower, at 14 per cent.

The trouble with all these surveys is that, for professionals and amateurs alike, the most important thing is not what investors say they think is going to happen but what they are actually buying and selling and putting into their portfolios.

It is by no means clear to me that the new-found optimism has yet produced any dramatic change in the balance of investors' holdings.

To the extent that changes have been made, it has been noticeable that the market's rally has by and large been led by the junk stocks in the market indices.

In other words, it has not been the companies with the strongest balance sheets and cash flow that have done the best.

It is former growth stocks that were blown out of the water three years ago that are now leading the market back-up. This again is, worryingly, not the pattern of behaviour you would expect to see if this really was the end of the market.

So while I am reasonably clear that the risk-reward ratio for genuinely long-term investors has swung back in the direction of equities, the present market rally does not yet look totally convincing.

It is clear that the US Federal Reserve is committed to flooding the markets with liquidity, and will stop at nothing to try to keep the US economy working reasonably near to full capacity in the run-up to the next election. The longer-term worries are whether the sustained recovery that the market is now expecting can be achieved.

It certainly looks unlikely from the point of view of corporate earnings, where the advances in earnings required to validate today's market levels look a tall order. This against the background of a market that is already still some 25 per cent to 30 per cent overvalued when measured against the replacement cost of assets.

As bonds look very hard to justify at today's levels, in the absence of genuine deflation in the US, probably the most interesting question investors can ask is whether they are actually looking in the right part of the world in the first place. Talking to one foreign-based fund manager last week, it is clear that finding good value in the US market today is difficult. The range of stocks on offer simply does not allow it.

It is clear that many overseas investors are finding the UK market attractive. Investors can now find a lot of companies whose ratings look very good compared with the burden of doing things yourself. The cash yield (the amount of the cash they are generating per share as a percentage of the current share price) of some companies is unusually high by historical standards.

The places that do now seem to be attracting renewed optimism are the Hong Kong and other Asian stock markets. While Hong Kong has recovered reasonably well this year, on longer-term valuation grounds, it still looks attractive. At the height of the Sars epidemic, investors were fretting about the loss of mobility that the epidemic might bring in its wake.

In retrospect, it might turn out to have been a shrewd time to buy the Asian region. Cartainly on valuation grounds, there is much to be said for a market that is trading on a p/e ratio of around 12 and a dividend yield close to 4.5 per cent. These kind of ratios have not been seen for a fair while now, and indicate that investing in Hong Kong might now be safer than it looks on the surface.

Because the US is the largest economy, it is tempting to lose sight of the fact that there is no law which says that its stock market has to be valued on the same basis as its counterparts overseas.

The expansionist monetary policy of the US Federal Reserve has injected a huge mount of liquidity into its home markets.

Some of this extra liquidity will undoubtedly find its way into overseas markets as well as the domestic US one. The underlying earnings potential of strong Asian companies is much higher than equivalent companies in the US.

There may well be plenty of bargains in the former's ranks, while US equities continue to carry a much higher risk.

This may well be a good time to start increasing your exposure to Far East markets, rather than trying to run too far too fast with the resurgent bulls in the mainstream markets.

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