It is time to take stock, for the bulls are clearly back. The rebound of the markets since March has blown away nearly all the "depressionists", that school of commentators who believed that the world was facing something similar to the Depression of the 1930s. Those of us who wrote then (albeit with a public health warning) that shares might perform very well in the medium term can feel more comfortable about our judgement.
However, the main developed world economies are only just starting to turn upwards, and there are genuine doubts about both the durability of the recovery and the ability of the markets to sustain their strong performance. In particular, you have to ponder what will happen when the exceptional fiscal and monetary measures to boost the economy have to go into reverse.
The best place to start is the US, partly because of the size of the market but also because there is very good historical data. Simon Ward, of Henderson New Star, has produced a nice chart comparing the Dow's performance this cycle with previous experiences of really bad bear cycles. The peak of the Dow this cycle was in October 2007, some six months ahead of the downturn in the economy. If you plot what has happened since then it compares pretty well with the experience since the peaks of January 1906, November 1919 and January 1973. The time that was completely different was the experience after the peak in September 1929.
So what happens next? Well, if the market follows those three cycles, the 1906, 1919 and 1973 ones, it should be back to some 90 per cent of its previous peak by the end of next year. The all-time high was 14,164 so I suppose you might expect the Dow at about 13,000 in another 15 months' time. There has been a huge recovery already but on this unscientific basis there should be another 30 per cent to go.
Other markets? Well, of course different markets will experience somewhat different results but it seems to me that the similarities between all the main developed country markets bar one are greater than the differences – the exception being Japan, where there has been a two-decade bear market. That is surely a function of the excessive monetary boom the country experienced in the late-1980s: because valuations were so outrageous and the debt burden so massive it has taken a long time to work through the excesses.
In any case, within the developed world, currency differences mean that different markets produce different results. This applies naturally to commodity markets too. Thus dollar weakness led to a record gold price the other day, but in terms of the euro gold is still below its peak earlier this year. Emerging markets, though, are different – distinguished by where the country is on the production cycle, for example, raw material producer or higher-end manufacturer, and by domestic monetary and political conditions.
Come back to the Dow because it will set the tone for the rest of the pack. Even with the present rise it has experienced a long period of underperformance, raising questions about the case for equity investment. I have been looking at some long-term work by Smithers & Co, the boutique investment advisers. Andrew Smithers looks at US data going back to 1801 and UK data back to 1900. He concludes that the US market has never given negative returns over a period of more than 17 years and the UK market more than 23 years. If you take world returns, they have never been negative over a period of 25 years or more. One message is that even if you buy shares at completely the wrong time, you will still eventually make money. Another is that if you can borrow money cheaply enough, it pays to do so and stick it into shares.
Obviously, though, it matters very much that you move into the market at broadly the right time. There have been a couple of clearly wrong times already this century, the past two market peaks. What can one sensibly say about what might happen next?
There are two ways into this discussion. One is to look at fundamental valuations, the outlook for corporate earnings and so on. The other is to ask whether the market is abnormal in some way at the moment and in particular whether it is being artificially supported by public policy.
On the first, you get into a debate about which valuation to take and I suppose you emerge with a general conclusion that shares in the US and UK are now priced about right. Put it this way, they are within 10 per cent of their historic norms. So, not great value, but not terrible value either. Earnings, however, are more positive – and earnings, that is, of "real" companies rather than financial ones.
I think that all of us are only just beginning to appreciate what the recession has done to improve corporate performance. Costs have been cut; companies have been restructured; and the weakest firms have gone to the wall, creating space for the stronger ones. So maybe you can talk fundamental valuations up a bit from where they are now.
The second way into the debate is to tread into an unknown land. We have never had interest rates at near-zero. We have never had "quantitative easing". We do, however, know that eventually interest rates will revert to a norm and QE will cease. The only issue is when. From a global perspective what happens in the US is much more important than what happens here. The US monetary base has doubled over the past year, from $800bn (£490bn) to $1,600bn. That is equivalent to more than 5 per cent of US GDP. Smithers & Co argues that the effect on asset prices of this policy has continued even after the rise in the monetary base ceased, but of course we cannot know what will happen once it goes into reverse.
I suppose the intriguing issue is the extent to which asset prices will be supported by low interest rates, even after QE has gone into reverse. Cheap money of itself did not support asset prices when they were on the way down. This was one of the reasons why it had to be supplemented with QE. But on the way up things may be different. And remember the situation is different when you look at a market in domestic currency terms and in foreign currency terms. The dollar is weak partly because of the Federal Reserve's commitment to a very loose monetary policy.
Turning to the UK, every time the Bank of England hints that QE will be extended, the pound goes down. That is because people do not trust the policy, believing that the Bank is deliberately trying to depress the value of the pound to gain economic advantage for the UK in a soft market for traded goods. Eventually, the policy has to result in inflation, as the Bank acknowledges and the markets fear.
My own instinct is that the main stock markets will follow the broad pattern of those three bull markets charted above. So, by the end of next year, the Dow could be around 13,000 and the FTSE 100 around 6,000. But the path will not be a straight line by any means and, as for what happens beyond 2010, the crystal ball clouds over.Reuse content