City: Bulls have stronger case than bears

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The Independent Online
IT'S not often you hear someone arguing the big bull case for equities these days. At most City lunches, the talk tends to be rather the reverse. The London market is far too highly valued for this stage of the economic cycle, people say, and as a consequence extremely vulnerable to any setback on Wall Street - which is displaying even greater gravity-defying characteristics than London. At best, we are in for a period of drift, seems to be the general consensus. Well, maybe they are right, but here's the more optimistic view.

Since Britain came out of the ERM last September, the London market has read the prevailing economic winds like a dream. Up until the turn of the year, share prices across the board rose strongly in anticipation of the economic recovery that had been so cruelly held back by the high-interest-rate, high-exchange-rate straightjacket of the ERM. Leading shares haven't done much since then - the FT-SE 100 share index is the same now as it was at the start of the year - but second-line stocks have continued to race ahead. The FT-SE 250 index is up nearly 10 per cent since the turn of the year and the FT-SE smaller company index by nearly 15 per cent.

Recovery now seems finally to be under way, vindicating everything the market has done since Britain came out of the ERM. Non-oil gross domestic product figures tomorrow are likely to show a 0.6 per cent rise - the first unambiguous rise for two-and-a-half years - officially marking the end of the longest recession since the Second World War. But as hard evidence of recovery begins to come thick and fast, old doubts seem to be resurfacing. That is not because the evidence is weak and uncertain. On the contrary, it's now coming in spades and, on the whole, it's much better than the forecasters were expecting. Last week's news that in March unemployment fell for the second month running was perhaps the most surprising yet. The first time the figures fell, the City wrote it off as a statistical freak; second time round there are many who refuse to believe it. It is rare, if not unprecedented, for unemployment to fall at this stage in the economic cycle. Normally, unemployment would continue to rise well into the recovery. With the Newbury by-election looming, there are plenty of reasons for viewing the figures sceptically. But however you cut the argument, it is now clear beyond any doubt that some form of economic recovery is under way. Moreover, all the signs point to it being a good deal stronger than the Government could have dared hope for at the time it abandoned the ERM.

So why the mood of caution at City lunch tables? The argument works roughly like this. Equities are already extremely highly valued on any historical basis. On Wall Street it is even worse. Wall Street is more expensive now than at any time in its history - obscenely overvalued. It doesn't come any better than this, the bears are saying - those of a nervous disposition should bail out. Share prices relative to book value are now higher than they were just before the great crash of 1929. On yield criteria too, Wall Street is more highly valued than in 1929 and only marginally lower than before the last big crash of 1987. It is true that corporate America cut its costs to the bone during the recession; even the slightest upturn should therefore produce a potentially dramatic recovery in profits.

But this is still a market being driven mainly by hope, and that cannot last forever. If the US recovery peters out - and there are unnerving signs of it doing so - then Wall Street is riding for a fall that will have a knock-on effect in London.

That's the bear argument anyway. The bull case goes like this. Conditions are wildly different from those before the crashes of 1929 and 1987. There is no speculative excess, and we are talking about economies pulling out of recession, not plunging into it. Furthermore, the upturn is going to be stronger and quicker than the pundits think, which in turn will lead to a big recovery in corporate profits. Valuations will therefore swiftly return to more normal levels.

Personal savings are being sucked into the equities market as never before. Normally when the small investor starts dipping his toe in the stock market, you can be sure it's time to get out; traditionally it has been as strong a sell signal as you can get. This time round, however, the small investor is being drawn not chiefly by the prospect of speculative gain but by the paucity of other places to go. With interest rates so low, there is little point in sticking your money in the bank or building society. You can get as good a yield - if not better - from equities.

For two or more years now, Wall Street has been sustained by exactly the same phenomenon, and there's no sign of it abating. Savings have poured into Wall Street like there's no tomorrow. Fidelity, the US's largest mutual, reports ever larger and larger inflows, and its discount brokerage is swamped by small investors wanting to buy stocks and shares. It is not quite like that in London yet, but it's getting that way. That is turning traditional valuations on their heads. Shares look expensive, yes, but the alternatives look worse value still.

With even the Bundesbank now apparently being panicked into cutting interest rates to head off looming recession in Germany, the situation doesn't look like changing for a long time. In Britain, too, the next change in interest rates is much more likely to be down than up.

So there's the bull case. You've got to be an optimist to back it wholeheartedly, but it's a good sight more compelling than the alternative. Don't listen to the pessimists. Relative to other investments, shares look the winners by a mile.