Turning points in markets are funny things. Just sometimes they are clear: there is that moment when everyone knows they have moved to an extreme position and the only way from there is up ... or down. This is particularly true on the upside.
The recent peak of sterling against the dollar at $2.10 was one of those and what is still the highest point that the FTSE has reached, 6950.6 on 30 December 1999, was another. Actually, it may be quite a while before oil gets back to $146 a barrel again too. I am relieved that I suggested in these pages on 24 April that: "Oil is in blow-off territory and a reaction in the price is inevitable, probably quite soon." I was a month early in that call and felt a bit silly as the price climbed on up, but timing is tricky and I suppose it is better to be broadly right than precisely wrong.
Perhaps the most famous peak of all was the one in October 1929 just ahead of the great crash, the popping of the greatest share bubble of the last century and the start of a four-year bear market in shares. But on the downside things are usually different: spotting the trough is harder than the peak. It is harder to think "this is ridiculous" in a world dominated by gloom rather than euphoria. Bull markets end with a bang; bear markets with a whimper.
Nevertheless I think it is a reasonable proposition that we may be near some sort of turning point in equities. In the US last week we had the seismic event of the rescue of the giant housing finance organisations, Freddie Mac and Fannie Mae. If you are looking for the big rescue that typically makes the turning point in a financial crisis, that would qualify on all scores. This was not just the biggest rescue in dollar terms, it was the biggest rescue in the history of the world, for the total liabilities for which the US government has taken responsibility are equivalent to about 10 per cent of global GDP.
That does not mean there will be no more stuff to come out, as the unravelling of Lehman Brothers last week showed. That is a huge mess too. But I was quite encouraged by the response to it: the markets seemed at least as upset by bad retail sales as they were by the potential disappearance of the US's fourth- largest investment bank. This suggests a sense of priorities: the real economy matters more than a financial institution.
To be clear, I am not suggesting that the US economy, still less the UK economy, is nearing any kind of turning point. You can say that just as the US led the world into the slowdown, it is likely to lead it out. But that moment is still some way off. As for the UK, the economy is only just starting to slide into negative territory and the turning point is further away still.
It is, however, the job of markets to anticipate. Typically equities turn between three and 18 months before the turning point in the economy, so you could believe that 2009 will be worse than 2008 – a view now widely reflected in the official forecasts – and still be looking for some sort of turning point in equities in the coming months. It is even possible we are past it: that the bottom of this cycle was last July when shares went below 5,200.
At the moment the UK share markets seem balanced between two views: cautious optimism on the one hand and firm pessimism on the other. Barclays Wealth, veers towards the optimistic, with the central forecast being a slow recovery in prices but with a wide fan of other outcomes. Barclays reckons there is a two-thirds chance that the FTSE will be within the two boundaries of the fan.
That would be the mainstream view and it would be supported by pricing evidence that suggests that shares are quite cheap by historical standards. Thus the price/earnings ratios in the low teens in most markets are modest by past standards and in the UK the dividend yield on the FTSE is on a par with the long-term gilt yield. As I say, that is the mainstream view and I happen to agree with it.
The best exposition that I have seen of the contrary view, that shares are still overpriced, comes from the boutique investment advisers, Smithers & Co. Andrew Smithers argues that to bring inflation back down the world will have to have a period of below-trend growth that will cut company earnings. Profits will fall even if there isn't recession. While shares have fallen in real terms by 50 per cent since the beginning of 2000, he argues they are still overvalued, largely because of this deteriorating outlook for earnings. He reckons that the US market is about 40 per cent over-valued, though the UK market is only 10 per cent over-valued.
The more optimistic view would accept that there will be pressure on earnings but sees two things that will help UK companies. One will be falling interest rates. Barclays expects the first cut before the end of this year and further falls through next year. The other is the impact of sterling's devaluation. The pound is at the bottom end of its 20-year trading range – statistically more than one standard deviation from its trend rate. That helps most companies' earnings, as about two-thirds of the revenue of FTSE companies is in foreign currencies, either in the form of profits of overseas entities or in exports. Of course you could say that devaluation of sterling means that the international value of the index is lower than it otherwise would be, but for a sterling investor, devaluation helps.
What I think can be said, even if you accept Smithers' arguments, is that UK shares are not terribly over-valued, even though the economic turning point is a year away and even if company profits are going to be weak. One further argument for equity investment now is that not only is it fiendishly difficult to get the timing right but some of the largest gains in markets occur in the early part of any recovery. In 1933 the US economy hit bottom but Smithers points out that anyone who invested in US shares at the end of 1933 would have received a real 9 per cent return over the next 30 years.
The analogy I like is the bus stop one. Imagine you want to catch a bus that comes at one hour intervals but is pretty unreliable. Better to get to the stop 10 minutes before the scheduled time and have to wait than to arrive two minutes before the hour and discover the bus went through early and you have to wait another hour for the next one.
We risk talking ourselves too deep into trouble
Suddenly it is fashionable to be frugal. You saw that last week in the contrasting reports from Waitrose and Morrisons. The former was struggling with falling sales; the latter was gaining from people switching to its good-value lines. An acquaintance in Paris told me all her friends were boasting of how they had saved money in one way or another. For many here, it is becoming a test of ingenuity how to spend less but still maintain a decent quality of life. Why?
The explanation starts with the data on confidence. While the economy has only just started to slow and, house prices apart, seems most unlikely to go through anything as bad as the recession of the early 1990s, confidence is exceptionally low.
In one sense, that is understandable for the news flow in recent weeks has been relentlessly negative. Airlines and investment banks are falling like flies and any business linked to the housing market seems to clinging on by its fingernails. But employment is still quite strong, exports are good and retail sales are not dreadful. Looked at rationally, people are more gloomy about the future than the conditions justify.
And the reason for that? Nearly half the workforce have no adult experience of a recession so don't know what to expect. So it is a new and troubling experience. For people in commercial jobs, it is tough to see the numbers going down each month, leading to worries about job security. Even those in the public sector can appreciate the squeeze on spending has begun. Everyone can see the Government is more or less helpless, even without the Chancellor suggesting that. This is not something people have been trained to understand; governments are supposed to be able to solve problems, not wring their hands.
The danger is that low confidence will not just result in greater frugality, which actually would be a good discipline.
The danger is that we will talk ourselves into a deeper recession than we need to – and if we do, we all know who will get the blame.Reuse content