Comment: Is it bad enough to start buying?

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The Independent Online
When things look dreadful it is time to buy. Yesterday was not the greatest of days to try to construct a bull scenario for the British economy or for equities. Britain's largest bank was saying that the recession might last another two years, and the largest wholly British company in terms of turnover, BP, halved its dividend. The brokers who talked of the FT-SE 100-share index reaching 3,000 by the end of the year must be feeling a little battered.

For contrarians, however, the very weight of bad news must itself be a 'buy' signal. They can make the rather unkind point that the banks that are so gloomy now are the very same banks that were absurdly over-optimistic at the height of the boom. If they had not extended their lending beyond prudential limits between 1987 and 1990 they would not be facing the write-offs they are making at the moment. For many people the very fact that the banks are in despair will be signal enough that better times are just around the corner. For the less easily convinced, though, there has to be something other than sheer perversity to support the bull case.

The rational case for believing that the recovery will start soon comes in the judgements of the broad span of forecasters. Even if, as seems likely, this year's GDP figure is down on last year's, hardly any mainstream forecasters have a negative for the second half of the year: even the pessimists reckon that the second half will be flat.

As far as the equity market is concerned, there are several ways of making the argument that share prices are very cheap. Not surprisingly the brokers have been doing this in the past couple of weeks, for every fall in the market can be sold to potential investors as an opportunity to buy. BZW has quantified just how cheap British shares are by the standards of the past quarter-century.

Two measures

The argument runs like this. The market is now on a price/earnings ratio of 13, with the prospective p/e ratio for next year in the 11-12 range. Historically, that is very much the bottom of the range since the early 1980s.

True, in the 1970s it went down as far as 6, but it has been above 10 since 1982, and the mid-point of its 1980s trading range has been 14. So on that measure, share prices are fairly cheap, though not outrageously so.

If, however, you take a different measure, the yield ratio (the relationship between the yield on equities and the yield on gilts), equities look very cheap indeed. During the 1970s and 1980s high inflation maintained very high yields on gilts. As inflation has fallen, so has the yield on gilts. This ratio peaked at over 3 in 1987, but the normal relationship has been between 2 and 2.5 for the past 20 years.

In other words, you would normally expect gilts to give double the yield of equities. Now the ratio is down to about 1.75. BZW points out that it has been lower than its present level for only five months during the past 24 years.

Of course this may prove the exception. It is conceivable, too, that gilt prices will plunge in the coming months: the Government falling and sterling leaving the exchange rate mechanism would cause that sort of mayhem. But, as BZW points out, when values become as extreme as they are now, there is a danger of the snap-back in prices that has occurred in the past. It is sticking to a year- end target for the FT-SE 100 of 2,750.

A less conventional case for buying equities has been made by Smith New Court. SNC has just looked at the ratio of sales to purchases of shares by directors of large companies in their own firms. This is on the grounds that directors know more about the trend of their own businesses than anyone else. If you follow what they do with their own money you not only tend to get a better share performance in general; you also get a good indication of market tops and bottoms.

This ratio of purchases to sales peaked in the second half of 1990; it then fell back, peaking again at the end of 1991. Both these occasions signalled good times to buy shares in general. Now SNC thinks the ratio has peaked again. If the experience of the past two years is any guide, now should be the time to buy.

Of course this is a short time-span, but directors' share deals have only recently been monitored in an organised way in the UK. However, in the US, where there is a longer run of figures, peaks in buying have also coincided with troughs in the market. This suggests that directors are good at buying shares when they are cheap.

Unclear signals

SNC goes on to list the shares of some large companies where directors have recently made large purchases - companies like Racal, P&O and British Land. Unfortunately it is not clear that these 'buy' signals are very useful when it comes to individual shares. The list includes BP; and in every one of the 10 shares mentioned the latest market price is below the average price paid by the directors. Maybe director share purchases and sales are a better guide to the market than they are to individual companies.

There are, inevitably, more general objections to the 'equities are cheap' thesis. One is that, while the British market may be relatively undervalued, the US one is quite the reverse, a case made by, among others, the Bank Credit Analyst team in Montreal. If Wall Street falls sharply, then it would be hard for London to make progress.

Another is that the long period of disinflation has changed the balance of advantage between equities and fixed-interest securities. This means that, far from equities yielding less than gilts, as they have since 1959, we will go back to a period where they yield more. The valuation indicators of the last 25 years are no longer relevant.

Still another is that the world economic outlook (as opposed to the British outlook) is deteriorating by the day, rendering the earnings assumptions made, for example, by BZW over-optimistic.

The reply to all this is to say that unless there were these substantial doubts, share prices would be much higher now than they are. This is the reply of the contrarian. Markets will always be a balance between greed and fear. Only when people are frightened are there good opportunities to buy.

We will see. There is certainly no shortage of frightened people at the moment: but are they frightened enough?