It takes two views to make a market. Well, actually vastly more, of course, because any market price is a balance between the multiplicity of views of the people buying and selling within it. But rarely is there quite such a sharp divergence of opinion about global share prices as there is right now.
On the one hand there is what you might call the case for the prosecution, which is that even after recent falls, share prices in the developed world are not properly discounting the probability of recession in the US, the impact that would have on the rest of the world, and most particularly the impact on company earnings. Shares, accordingly, are still too high.
The case for the defence, on the other hand, is that unless you take a really dire view of the future of the world econ-omy, shares are quite cheap. Bear markets rarely last for more than a year – the fall from 2000 was exceptional – and while we are heading into a slowdown, the markets will soon start to look across the valley to the sunlit uplands ahead.
These two views tussle all the time, with the defence side rallying and counter-attacking last week after the pretty devastating attacks of the first part of the year. But I think even the most robust defenders would acknowledge that there will be more battles in the months to come. In short, the markets are exceptionally volatile now and there is no end in sight to that.
It will be fascinating to see how this is resolved. On a long historical view, you would expect the occasional year when share prices end up lower rather than higher. Taking British data, the three and a bit years of decline from the start of 2000 to the spring of 2003 was once-in-a-generation stuff – the worst bear market since the 1970s. Now we have had five years of UK share prices being up at the end of the year – they were just up at the close of 2007, though they had come well off their peak. That long run of rises is also unusual.
So it would be quite normal were this bear market to last well into 2008 and, even if things pick up in the autumn, it would also be quite normal were the main indices to finish the year down.
This matters a lot, and not just in terms of the impact on people's pensions and savings. It matters because companies worldwide look like being weaned off debt finance in the months ahead, and having reasonable access to equity markets will enable them to pull through this cycle in better shape.
No one wants share madness; we had enough of that in the late 1990s. But the more staunch the markets, the more sustained the recovery is likely to be, and the more solid the recovery, the more the markets will regain their confidence.
In recent days there has been a range of papers about the direction of share prices, and it is impossible to do justice to all of them here. However, a few seem to me to capture the divergence of views particularly clearly. Start with the more bearish position. One key question is whether present expectations for company earnings are too high. Among those believing they are is the team at ABN Amro, who argue that the consensus forecasts, which have seen only modest downgrades, do not take into account the deterioration in the US economy, rising cost pressures and, for Europe-based companies, the stronger euro. Earnings Denial, it calls its paper.
Another, even more bearish, view comes from the boutique adviser Smithers & Co, whose latest paper is called The Case Against Holding Equities Today. The argument is that the US market is still overpriced and that analysts' estimates of earnings have not only been consistently over-optimistic but the bias in their forecasts is worse when profits are falling.
A slightly different approach comes from Goldman Sachs, which considers the possible shape of the global recovery. It looks at the economy rather than earnings as such, but the message is that a U-shaped recovery is more likely than a V-shaped one. A U would naturally be worse for company earnings ... and let's not talk about the chances of an L.
In another paper, Goldman notes that equity prices are shaped by the trade-off between growth and inflation. It thinks inflationary pressures will dissipate later in the year but there is a risk they won't and that growth will come in lower than expected. But it does not foresee 1970s-style stagflation. It notes too that the global industrial cycle has remained remarkably resilient so far, so I suppose one should count Goldman as pretty balanced between the bear and bull arguments.
For the bulls, the straightforward argument is well made by broker Charles Stanley, which reckons that we have had nine months from the summer peak and, at worst, a 20 per cent fall in UK share prices. By the standards of the early 1990s recession, that ought to be setting the market up for a recovery quite soon, particularly since the prospective price/earnings ratio of 10.7 is well below the historical average of 14.
A more mathematical approach comes from Longview Economics, which foresees a W shape. It argues, though, that we may be nearing the end of the market downturn, noting that on a contrarian view there is a strong case for buying shares. One indicator is the overbought/ oversold index for the US market. Another is the risk appetite, again signalling a "buy". Longview does expect another big sell-off, so we are not through the woods yet, but by the middle of the summer it thinks the markets will be anticipating the recovery.
So there. I don't think it helps much to try to be too clever about these things. There are times when markets are clearly heading into never-never land – that happened in the dot-com boom – and there are times when their gloom seems out of place with reality too. British banks' shares now are priced on the basis that there is an awful lot more bad news to come out, which is possible but perhaps not on the scale the share prices suggest. What can be said is that, on a very long view, UK shares are quite cheap and may well get cheaper yet. Indeed, they probably will.
The view remains intact that eventually equities will provide better overall returns than either bonds or cash. But it may take a long time for that to be evident if you start in the wrong place on the cycle.Reuse content