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Hamish McRae: Why this bout of irrational despair may take time to correct itself

Thursday 13 March 2003 01:00 GMT
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Just as there was irrational exuberance so too can there be irrational despair. But when the first phrase was made famous by Alan Greenspan he was far too early, for the market went on climbing for more than two years. It is conceivable that anyone who now warns that the despair has got out of hand is also far too early.

The difficulty at a time like this is to be able to stand far enough back to get a perspective. This new bout of weakness of share prices carries the bear market into the territory of the early 1930s and early 1970s crashes. The point that has been made here, as in many other places, is that this sort of thing happens only once in a generation. But not many people can remember that far back – certainly not the fresh-faced analysts who write the broker circulars.

For an independent perspective in times of trouble I always find it comforting to go the editors of the Bank Credit Analyst in Montreal. They are a pure research house rather than being practitioners and I suspect that the physical distance from the main money centres of New York, Boston and Toronto also helps them stand back.

The latest edition of their international outlook makes several helpful points. They acknowledge that the prospect of war could test markets severely, particularly if the timeframe for action is pushed much beyond the middle of this month – pushed indeed beyond now. They also admit that things will turn on whether there is an early and favourable outcome to the war. But despite the fragility of consumer, business and investment sentiment they believe that there are several reasons to be optimistic about the world economy and that there should be a cyclical equity rally over the next six to nine months. That will not signal the beginning of a new bull market but it will mean that the relentless declines of the past three years will end.

There are, to be fair, warning signs about the US economy. For example consumer confidence plunged in February. But housing remains strong and the US service industries are still growing. Asia is in good shape, with domestic demand in China growing well. (Imports are running up 30 per cent year-on-year.) The smaller "emerging" economies are also growing. For the moment, growth in both Europe and Japan remains disappointing, but there should be some recovery later in the year in Europe and the ECB will clearly keep cutting interest rates through the summer.

So there should be continued growth of some sort in large parts of the world – though this does depend a lot on continued growth in the US. Will this be enough to end the bear market?

If you look at the rate of change of share prices over the previous year, the remarkable thing is the extent to which all the major markets have moved in the same direction in recent years – as the small graphs show. Investors are exceptionally gloomy, as you might expect, but that creates a situation where shares have been oversold: all that is needed is a hint of good news for them to rise again.

This would be supported by rising profits, by a global dividend yield, which at about 2.5 per cent is back to early 1990s levels and by a global price-earnings ratio of 15, again much the same as in the early 1990s.

The result is that the risks are low. The BCA team calculates a risk indicator for share valuations, liquidity and momentum. This signals a reversal of recent weakness in equities. So there.

Now the less good news: the boom in bonds may soon be over. The flip-side of equity weakness has been bond strength. This is one of the reasons why the collapse of share prices has not had an even more devastating effect on the financial system. Most long-term investment funds will have a mix of equities and bonds and the weakness of the former has to some extent been offset by the strength of the latter. Bond portfolios may now be at risk.

For a start, there will be a huge surge in the supply of fixed-interest securities as government deficits balloon. Next, bonds are technically overbought when judged by the same criteria as equities. Most fundamentally BCA believes that the 20-year trend of disinflation may be drawing to a close. Certainly you have to have a clear judgement that inflation is dead to want to buy 20-year fixed interest securities yielding only 4 per cent.

We will see. The point of articulating the arguments above is to show that rationally, on a long view, we ought to be somewhere close to a turning point. Yes, some of us thought that last October too. But on a 10-year view, being six months too early might be considered none to great a sin.

When things turn, will markets all move together?

In the last great bear market of 1974/5, the US market turned in the autumn while in the UK the turning point was the first week of the new year. But the gloom in Britain was intensified by the combination of very high inflation – even higher than the US – and an unintended tax squeeze on companies. We had also just experienced a miners' strike and the fall of the Heath government.

There were actually rational reasons to be very glum about the UK's prospects in early 1975: the IMF bail-out was still 18 months off and the final collapse of Labour's winter of discontent three years away. Yet markets shot upwards.

So markets can recover even when fundamentals look pretty bleak provided investors feel that values have become so absurdly low as to make them worth buying. It would be perfectly sensible, then, to expect a reasonable recovery in the coming months despite whatever misgivings one might have about the medium-term growth prospects for the world economy.

If that is right, try these three suggestions.

Expect, one, a bounce in share prices over the next six to nine months, with a recovery of at least 20 per cent from present levels.

Two, expect an end to the boom in gilts, with fixed-interest securities in general ending the year down, not up.

Three, expect two or three tricky years, where shares move pretty much sideways, maybe up on balance, as governments wrestle with rising deficits and the world economy achieves sub-par growth.

This is not a particularly uplifting prospect. It suggests there will be at least another couple of years of difficult adjustment while people, companies and governments all get their finances back in order. It would be consistent for several major economies to dip back into recession. But the thing to be clear about is that a lot of bad news is now priced into the markets. We do not even need good news; the mere absence of bad news should be enough to start restoring confidence. Unfortunately the politicians in several countries have been rather good at keeping the bad news a-flowing, and may continue for a while yet.

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