Bulls may sober up

The optimistic case for stock markets at the moment is simple enough. The yields on offer make equities look attractive relative to most alternative 'homes for money'. Moreover, the attractiveness of equity yields has been reinforced this summer as yields on bonds - the main alternative investment for most institutions - have tumbled around the world. In the face of the US Budget deal and a surge in optimism about inflation, bond yields have now fallen to their lowest level for a generation. In consequence, equity markets on both sides of the Atlantic have been touching new peaks in recent weeks.

The argument for regarding equities at current levels with a degree of caution is equally simply stated. The historic price-earnings ratio on the UK equity market this month has risen through 20 times earnings. What that means is that investors are now paying pounds 20 for every pounds 1 of company earnings. By all the historic yardsticks that is extremely expensive.

Indeed, investors have only paid a significantly higher price for equities once, briefly in the late 1960s, when the p/e ratio on the market topped 22. Even if we are heading back to 1960s-style economic conditions of modest inflation and reasonable growth this now looks to be largely 'in the price'. On this basis the scope for further advances from here looks very limited.

Investors are thus now confronted with sharply divergent messages from the two main valuation measures used in looking at equities - yields and p/e ratios. Which should they pay most attention to?

The p/e ratio on the market may be less expensive than it might seem. This measure in effect values the market in terms of 1992 earnings, hopefully the low point for the company sector in the current cycle. With analysts predicting pre- exceptional earnings growth of around 15 per cent this year, however, equities should shortly start to look rather less expensive.

Any willingness to pay over the odds for shares with an eye on recovery potential nevertheless needs to be tempered by evidence from the company sector itself that all is not entirely well. The CBI monthly trends survey, for example, has recently been sending some distinctly ominous signals for those looking for a rebound in earnings sharp enough to push markets on still further. Moreover, the first few weeks of the reporting season have seen companies as diverse as BOC, Hanson and BICC all relay the same message - there is a recovery under way, but it remains slow and patchy. It is plain, in other words, that for many companies, life remains tough.

If the less than euphoric message from many managements sits oddly alongside the electrifying advance we have recently seen in share prices, it is utterly consistent with the upbeat mood now driving bond markets. It is more than plausible to suggest that the optimism breaking out on inflation reflects a hesitant pick-up in activity, which is depriving many companies of the kind of earnings momentum they would normally expect through the recovery phase.

The question marks about earnings momentum also raise queries about the yield comparisons that are apparently now so supportive of equities. Dividends are currently taking a record share of corporate earnings. That leaves little margin for error. Indeed dividend flows into the market this year have suffered the sharpest fall on record. Looking out, moreover, shareholders must expect unusually low dividend growth for some time as companies use recovering earnings to rebuild reserves. Equity yields thus look attractive relative to other yields for good reason - they do not offer the normal growth prospects we have become used to over the past 20 years or so.

The problems flowing from the patchy nature of the current recovery and the stretched support for equity dividends can all be expected to resurface over the coming weeks as companies' results start coming in thick and fast after the summer holidays. After the summer excitement in bond markets, this looks like injecting a note of reality into equity investors who may begin to realise why the inflation outlook remains so good around the world.

It is notable, for example, that several of the first wave of companies to report have seen their share prices subsequently languish, in spite of results broadly in line with market expectations, as investors have picked over the detail of the figures and found little to get excited about at current valuations. This could well set the tone for the broader market through the autumn. A full-blown bull market without bullish companies is a curious animal that seems unlikely to survive long. After the recent party, the mood could become much more sober through the autumn.

The author is equity strategist at SG Warburg Securities.

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