Shares are back, but the scars of 2000-03 should not be forgotten yet

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The Independent Online

It has been a long haul and some of us are not there yet. But the fact that the Dow Jones index is back to its previous peak in early 2000 is a fair measure of the scale of the recovery.

That peak was followed by three years of declining prices, something that happens only every 30 or so years and some categories of shares, most obviously the hi-tech ones, have still to reach their previous peaks, assuming that they are still around at all. UK shares are not quite back either. But while the Dow is a narrow index and does not include the hi-tech shares that boomed most dramatically in the 1998/9 bubble, it is not a bad benchmark of global confidence in equities. Shares are back.

You can see this in the first graph. This starts from the beginning of 2001 rather than 2000 so misses out the first year of the decline, but of you were to start from there global equities have produced a similar return to global government bonds and both have comfortably beaten cash.

This is what you would expect on a long view. Indeed on a very long view equities have always beaten other classes of investment, including property. But that might mean waiting 20 years, just as it might mean waiting up to 10 years for shares to reach a previous peak. I have done a quick tally on UK share cycles this century, taken from the annual Equity Gilt Study, produced now by Barclays. It took until 1919 to get back to the 1909 peak, 1935 to get back the 1928 peak, 1945 to get back the 1936 peak, 1954 to get back to the 1948 peak, 1967 to get back to 1959, and 1978 to get back the 1972 one.

Those are absolute levels. If you adjust for changes in the cost of living there was little net change in the price of UK shares between 1900 and 1960, but then that did include two world wars with all the burden of post-war reconstruction, plus a global depression in between. Since 1960 prices have more than doubled in real terms and, of course, shareholders have had an income from their investment throughout the whole period.

So on a very long view the roller-coaster ride we have just experienced is pretty normal. But a long view merely gives perspective on what has happened: it says nothing about what is to come. To try to think through the next stage of the recovery the best starting point is consider where we are in the economic cycle.

The second chart, from the economics team at Deutsche Bank, suggests that we are now seeing a mid-cycle slowdown but only that. The graph shades in the cycles since 1970, suggesting that we are now perhaps two-thirds of the way through the one that started in 2001. Note that this is world GDP growth, not just developed world or G7 growth. Note too that the bottom of the two most recent cycles, the early 1990s and early 2000s, is higher than that of the early 1980s one. So it is at least plausible that the bottom of the next cycle will still see reasonable global growth.

Insofar as growth is good for the world's corporations and their owners this should give some comfort to share-buyers. Very high company profits worldwide are one of the main reasons behind the present recovery.

There is, however, another: cheap money. To counter the 2001/2 slowdown the world's central banks pumped in money and slashed interest rates. The growth in global money supply in 2002 reached 14 per cent a year. By last year this had come back to about 5 per cent but in recent months it has crept up again. At any rate it is expanding much faster than global output. That is why the world's central banks are having to increase interest rates: the European Central Bank probably today and the Bank of England either this month or next.

On a long view, interest rates now are still quite low. They were negative in real terms between late 2002 and the middle of 2005 (third graph). In other words, global interest rates were lower than global inflation. That has been corrected but the legacy of these low interest rates has, in the US and UK in particular, been a surge in household debt. That debt will be a big drag on us all through the final years of this cycle. My own view is that household indebtedness, exacerbated by falling (or at least not rising) prices of residential property, will be one of the key elements in the end of this cycle.

At the moment we have falling house prices in the US and it will be interesting to see how far this moves through the system to constrain growth in consumption. We don't yet have falling prices in the UK, indeed rather the reverse for some sort of pick-up has occurred in most segments of the market. (I gather that one of the few bits of the residential property market that has sagged is Connaught Square in London, soon to become the home of the Prime Minister.) But in Britain as a whole, as in most markets bar Germany and Japan, valuations remain stretched.

As far as shares are concerned, valuations do not look particularly stretched. The classic measure of price-earnings ratio is for most markets in the mid-teens, which is more or less normal historically. On the alternative measure of ranking them relative to bonds, US shares are the cheapest they have been since 1980. Chris Watling, who runs Longview Economics, notes that to argue that they were not very cheap on this measure would be to argue that we're back to the macroeconomic conditions of the 1970s and that this must be wrong. That was a period of very poor economic management globally. Whatever we think of current management, the world economy is not as badly handled now as it was then. He expects a strong US share market for the next 12 months.

That seems perfectly plausible. There will be a year of falling share prices some time in the next three or four years and that could come next year. Or there could be another bump soon for October has long been, for share markets, a tricky month. But the world's financial markets do not have that euphoric feel to them, as do some of the property markets. Here in Britain we would have had higher share prices had our pension funds not been switched to fixed interest securities by ill-framed regulation. The fact that people are starting to realise that this is not in the long-term interests of pensioners suggests that there will be a re-balancing of investment back towards equities in the reasonably near future. Meanwhile, there are opportunities for investors not constrained by such regulation.

So the long march back can continue a while yet. To say that is not to discount the risks, and a lot of what happens to share prices will be determined by investors' appetite for risk. The scars of 2000-2003 remain. Once people forget about that will be the time to worry. Not yet.

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