Comment: Bears lying in wait on Wall Street

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America is too cheerful. Or rather, it is too cheerful for the good of investors in equities. The real economy has undoubtedly been recovering at a slightly faster rate through the autumn, though this did not show through in the statistics in time for the election. This will now be given a further spur by a marked post-election improvement in confidence: the 'feel-good' factor is at large. The president-elect Bill Clinton is calling his high-level strategy meetings with business leaders and it is somehow hard to believe that all those corporate jets flying down to Little Rock might result in nothing very much.

Next year the US will almost certainly be the fastest-growing of the Group of Seven large economies. Its interest rates will remain low well into the year, and the dollar will probably continue its recovery. But Wall Street, equally probably, will be a different story.

The bear case for Wall Street has to start with a public health warning. This is that no one is going to get the timing of the next bear market in US shares exactly right. All that can sensibly be done is to explain how a bear market is building and why, at some stage in the next few months, the markets are likely to respond to this.

In fact there is probably enough momentum for the present strong market in US shares to carry on for the first part of next year. But whereas in the Sixties, Seventies and and early Eighties the US stock market tended to rise quite swiftly and then fall only slowly, in the late Eighties it rose slowly and fell fast. Twice in the past six years it has lost more than 20 per cent of its value in a couple of days. Given the pace at which adjustments can take place, the prudent investor would leave the final few percentage points to someone else.


The bear case rests on three main planks: the forthcoming turn in the interest rate cycle; the present very high valuations; and what might be called the 'fizz factor'.

Now that the recovery seems assured, it is very hard to see any further decline in dollar interest rates. It looks very much as though they hit bottom when - measured by the three-month eurodollar rate - they fell to just over 3 per cent in September. The market view, based on the Liffe futures contract, is that they will rise steadily through next year to over 5 per cent by the end of 1993. (By taking the implied interest rate from Liffe contracts you see what the markets actually bet will happen, rather than what the economists predict will happen.)

Now it may well be that dollar rates will climb more slowly. That, for example, is the view of the Nomura Research Institute. It thinks that whatever programme the new president adopts to stimulate the economy, there will be no adverse impact on either inflation or the fiscal deficit. Since it is fears about both of these that are helping to drive US interest expectations, if the NRI is right the upward climb of rates may be slower than the market currently expects. This view is echoed in New York, where, for example, Salomon thinks that the cyclical rebound in short-term rates will not come until the end of next year, maybe not even until 1994; Goldman Sachs also thinks interest rates will remain low through 1993.

But the trend will still be up rather than down. The experience of the past three years is that interest rates have become a particularly important force determining share prices. They are more important that they used to be, probably largely because of the explosive growth of money funds in the US, which give investors easy access to money market interest rates. All investors need is the expectation of higher returns and they can move very swiftly. Share prices may well advance further, but from now on they will be vulnerable to any upward move in money market rates.

Besides, shares are by historical standards expensive with the price/earnings ratio around 24, compared with a 'normal' range of mid-teens. The bull market is now more than two years old. It has been sustained against falling company profits by the expectation of a sharp rise in such earnings as economic growth speeds up. Profits will climb next year, but you have to assume a very sharp rise to bring the price/earnings ratio much below 20; you can argue it down to about 18 if you try really hard. It is the job of markets to anticipate rises in earnings; once the firms deliver the profits, the market is looking for the next squeeze.

But perhaps the most powerful reason for being cautious is the fizz in the market at the moment. Sentiment is always hard to measure. It is clear that there is not the mad euphoria of, say, the summer of 1987 just ahead of the October crash. But there is some froth - witness the rise in the price of shares of smaller companies relative to the big ones.


One way of measuring this is to look at the price of shares on the over-the- counter market of Nasdaq, or the 5000 Wiltshire index, relative to that of the New York Stock Exchange. These two indices have both been shooting up since early September. Of course, they may have further to go; indeed they probably do. But they are signs, maybe early signs, that investors are getting too cheerful.

All this may seem a little sour. The new president has not begun his programme, and has inherited a significantly stronger economy than most people thought at the time of his election. Within the US there are plenty of securities houses still arguing that shares are not overvalued. Goldman Sachs is one, arguing that the prospects for low inflation and low interest rates through next year justify a higher valuation than many models give.

This, however, is classic bull-market psychology. Investors actually operating from New York, forming their judgements there, are inevitably much more involved with the swing of ideas there. Back here in London we are not just a more ill-tempered lot; we also look more naturally at alternative equity markets in the Far East and in Europe. Objectively these seem to offer better value.

It is not quite that the London view of American equities is bearish while the New York one is bullish - there are enthusiasts in London and bears in New York. But what happens to US share prices will be an interesting test of stock market judgement: does distance add perspective, or does it just mean we cannot see what is going on?