City & Business: Not many dead but shares lose their swagger

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THAT was the crash that never was. World equity markets had a turbulent week with London's FT- SE 100 index of leading shares falling nearly 100 points, but it was far from the catastrophe some had predicted. There's no doubt, however, that markets have been badly rattled by the Federal Reserve Board's decision to raise interest rates for the first time in five years. Analogies come thick and fast: the first sounding of the alarm bell; the tremor before the earthquake; the squall to be followed by the storm.

Alarmist talk, perhaps, but it's clear a fundamental change - a significant shift in the market's behaviour - has occurred.

In investment terms, we now live in an altogether more erratic and less predictable world. Just look at what happened to gilts last week: when the Chancellor, Kenneth Clarke, cut interest rates, the gilts market fell. Normally it would rise in such circumstances; a fall is as rare as snow in summer.

There are other unseasonal happenings, too, not least the spectacle of leading equity strategists at a loss for a view.

As investors lose their nerve and confidence, the markets no longer seem willing to obey the laws of nature. Stocks might go this way or that but then of course I could be wrong, at least two strategists admitted to me last week with uncharacteristic self doubt.

Even the normally bullish Nick Knight, chief equity strategist at Nomura, has dramatically altered his stance. Though he sticks to his year-end forecast of 4,000 for the FT-SE 100, he predicts a thoroughly miserable time for the next week or two with the index falling to 3,200 or less. Richard Kersley, equity strategist at BZW, isn't as gloomy but he also believes there's been a decisive break with the past bull trend.

For the past year and a half, share price valuations have been driven primarily by the move towards lower interest rates. The bull market has now reached its mature phase, he argues. With interest rates on the way up, stock prices need to be supported by something different - sustained earnings and dividend growth. Over the past three years, equities have risen about 60 per cent in value but dividends have grown only 1 per cent. That now needs to change. Put another way, yields need to start rising once more and there are only two ways that can happen: either dividends must grow or share prices must fall. But the most gloomy and in many respects compelling prognosis comes from David Roche, at Morgan Stanley. He's predicting a 15 per cent correction in London and New York at some stage in the next year or so. In most people's book, that would amount to some kind of crash. The market is looking for an excuse to fall, he says.

The counter argument is that there's so much liquidity, such a wall of money out there with nowhere else to go except into equities, that - in a low-inflation environment - present sky-high valuations can be sustained for ever.

Well maybe, but probably not. Equities have been sustained by low interest rates because they look good value against bonds and deposits. However, the only reason they show a better return than, say, cash is that they keep rising. If they stop rising, they look less attractive than cash, particularly if interest rates are on the increase. From here on in, you'll be seeing the dollars 100bn a year flow of hot money out of the US into foreign markets progressively turned off, Mr Roche says.

Even if you look on the bright side, even if you suppose there's not going to be a crash at least for the foreseeable future, it's clear that the best is over for equity markets. The brave investor sells at this point. But then of course I could be wrong.