Hamish McRae: Outlook brightening, but message for investors is still caveat emptor

There is plenty of money to invest and cash brings low returns but it is hard to find value in shares
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The Independent Online

The Sky is becoming a little less dark. Industrial output in the US may be turning up. Unemployment in Germany is falling a little less slowly. The UK shops had a good Christmas. And the markets, reflecting this brighter outlook, have made a good deal of progress since their low point towards the end of September. But how secure, how real, is this progress?

The Sky is becoming a little less dark. Industrial output in the US may be turning up. Unemployment in Germany is falling a little less slowly. The UK shops had a good Christmas. And the markets, reflecting this brighter outlook, have made a good deal of progress since their low point towards the end of September. But how secure, how real, is this progress?

That is the new question. The old question was: when will the world economy bottom out? We don't yet know the answer to that one, of course, but we can begin to make a decent guess. That guess would be that the bottom for the US is sometime this spring, followed about three months later by the eurozone. So we are not there yet but the end of recession is in sight. If this is right, the UK will escape recession altogether, though some segments of the economy will continue to find things very tough.

The fact that the turning point is past does not, however, say anything about the nature of the upswing. That will be the key issue for most of this year.

What can we say that is sensible about that? Well, I suppose the first point to make is that an enormous amount of money has been pumped into the system by the world's central banks. Obviously interest rates have been slashed but in addition the money supply in the US, the eurozone and indeed the UK has soared. As rates have been cut, people and corporations have increased their borrowings, which has the effect of increasing the money supply. (Think about it: you borrow from your bank, pay the money over to someone else and it then appears on their bank account. So the money stock rises.)

In the past, the danger has been that the additional money simply increases prices. This has not happened this time for reasons that we don't fully understand yet. What it has done is to relieve pressure on financial markets and finance the modest recovery in share prices.

It is best to start with the US partly because the US economy is leading the cycle and partly because US financial markets give a lead to European and UK ones. One useful measure of US financial stress is the index compiled by the Bank Credit Analyst (BCA) group in Montreal. It was at crisis level at the end of 2000 but has fallen sharply since the Fed started to cut rates a year ago. As a result the US financial system has been able to absorb the impact of the bursting of the hi-tech bubble and of course the attack of 11 September.

During the early 1990s recession the main pressure came from property companies going bust, which hit the banks. This time it has been the securities markets that took the strain. Nevertheless on historic measures, shares are still quite expensive, creating a practical problem for investors. There is plenty of money to invest and cash brings very low returns. But it is hard to find value in shares.

It is hard to find value because profits have collapsed. The bottom graph shows what has been happening to operating profits of large US companies. Published earnings may be rather better because companies in a mess tend to take one-off charges against income. (This week AOL Time Warner said it will take a one-off charge of between $40-$60bn this quarter, among the largest ever taken by a commercial company.)

As you can see profits have fallen faster than at any time since 1960. To some extent this fall reflects irresponsible accounting – earnings were over-inflated in the late 1990s – rather than a deterioration in underlying performance, but it is a bit of a clunker however you explain it.

The tension between loadsa money swishing around and nowhere attractive to put it will dominate US financial markets for the rest of the year. Don Straszheim, the former chief economist of Merrill Lynch, now running Straszheim Global Advisers, puts it succinctly in his new newsletter: "All want to be bullish on economy, on markets. Up is more fun than down ... But some p/e's [price-earnings ratio] already far too high. Red flag."

The investment message that emerges from this analysis is very much caveat emptor. The BCA team reckon that the markets will be much more like those of the 1960s than anything that current investors will find familiar. Markets will be cyclical. They may well be flat overall but there will be plenty of ups and downs on the way. Getting timing right will be very important, in contrast to the "buy and hold" rule that has held very well for the past two decades until 2000.

Don Straszheim comes to much the same conclusion: it will be a traders' market and a stock pickers' market. "Buy on the dips," he urges.

The interesting thing about both these position is that they come from independent advisers, not from the mainstream investment banks that have been so dreadfully, almost wickedly, over-optimistic for the past two years. Implicit in both these independent views is that there will be bad news ahead. This could be further terrorist attacks, very weak consumer spending, a really serious banking collapse – who knows? The key point here is that ordinary investors should be prepared for bad news, even if the markets are not.

Does the position change if one looks outside the US? Not a lot. Valuations in the UK and in the eurozone are on average more reasonable than in the US, but it really is unlikely that the eurozone will bounce back faster than the States this year. One of the great lessons of last year was that the size of the eurozone did not protect it from the debris of the US downturn. Yes, conditions for growth should be solid enough but given this experience it would be naive to expect it to outperform the US to any significant extent.

In the UK we are exposed to a much slower rise in consumption as and when interest rates have to be raised. That will hit profits. As for Japan, well, the balance of probability is that there will be some cathartic event this year, perhaps a banking collapse that will shake the world economy as well as the Japanese one.

Pull together these concerns and my guess would be that there will be only a halting, uncertain recovery this year. There may even be a double-bottom to the recession in the US. Economies are self-healing unless policies are really dreadful (Argentina, Japan) so the doubts about this year have to be seen in the context of a real recovery being eventually secured. But do not expect it to get under way until 2003.

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