City: Hope springs eternal for equities

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The Independent Online
IT IS hard to fathom, isn't it? The gap between stock market performance and what's happening in the real economy seems wider than ever. Here we are with the most unpopular prime minister since the war, the Tories being slaughtered in the polls, the Government in disarray, the economy - while showing the occasional twitch of life - in the abyss of recession, our major companies still hugely gloomy about the outlook, and despite it all, share prices are hitting record highs, bringing small investors flooding back into the equity market as never before. Walker Crips, a London firm of stockbrokers specialising in private clients, reports its highest level of interest and business since 1987.

To most people, it must look as if the stock market belongs to another world, another universe even, and it must confirm what they always suspected; the stock market is little more than a casino that bears about as much relation to underlying economic and political realities as a 10-bob note. Over the past 10 years, the FT-SE 100 index, which measures the performance of Britain's leading shares, has more than trebled. If you look at the long-term charts, the 1987 crash and the bear market that preceded Britain's exit from the ERM seem no more than blips, mere corrections, in an ever onwards and upwards march. It's as if the recession never happened; share prices seem to have been largely oblivious to it, utterly divorced from reality.

The truth is a little more complex than that. One of the key characteristics of stock markets is that they reflect expectations of the future, not the reality of the present. With the economy apparently on the turn for the better, you would therefore expect share prices to be looking forward to brighter times; in stock market terms, it would be a pretty rum old world if they mirrored the present economic malaise. The dollars 64,000 question, of course, is whether the market is reading the runes correctly.

Like the gaming table, markets are driven by powerful psychological influences - greed, hope, fear and despair being the primary emotions. Hope and greed have dominated sentiment throughout the recession; in its present mood, the market seems to think you can live on hope for ever. It has been a feature of the stock market over the past couple of years that bad news which undermines its rosy view of the future is conveniently ignored, while anything remotely close to good news is seized on and used to inflate stock prices higher still.

Why have share prices risen so high, and how much longer can the bull market last? The stock market has always been a gambler's paradise, but there's more to it than that: it is also the ultimate repository for vast amounts of wealth and savings. The fund managers responsible for investing that wealth are not meant to be in the business of gambling; their function is to find best value. Share prices may seem absurdly overvalued, the market may appear to be riding the crest of a tidal wave of speculation that any moment now must surely come crashing down, but the fact is that despite it all, they still represent better value than the alternatives.

It used to be a pretty reliable rule of thumb that you bought the equity market when the average yield rose to 6 per cent or more, and you sold it when it sank to 4 per cent or less. Today the yield is well below 4 per cent, and still investors are buying and the market is rising. Wall Street is even worse. It is now more highly valued - both in terms of yield and stock prices relative to book value - than before the crashes of 1929 and 1987. We are in uncharted waters - or at least, waters not sailed through for 20 years or more. Those of a nervous disposition ought to be turning back; share price valuations don't come any better than this.

In the present environment however, traditional valuations have begun to count for nothing. With interest rates falling across Europe and the outlook still good on inflation, particularly in Britain, bond markets too have been testing new highs. London shares, though expensive in historical terms on any measure you care to take, still look good value relative to gilts, the rate of return on cash deposits and overseas stock markets.

Furthermore, the argument runs, when valuations were last at this sort of level - just ahead of the 1987 crash - we were at the top of the economic cycle - not, as now, at the bottom. There's little sign of any speculative froth in this market, and assuming that the sort of growth in earnings the market expects for the next two to three years comes through, traditional valuations should be rapidly restored. I guess it's just about possible to go along with this, but only just. I don't see the market heading for the frightful correction that some doomsters predict, but it's equally hard to see it rising much further beyond this point - at least for the remainder of this year. Further cuts in interest rates, when they come, will obviously be a boost, but shares are going to want to see hard evidence of sustained recovery, of hope being fulfilled, before making the next big push upwards.

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