Jonathan Davis: Why I'm bullish about the bears

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The Independent Online

Contrary though it may sound, I do not share the assumption of many City people that a continuation of the current bear trend in the market would necessarily be a disaster. There are several reasons for thinking a return to a more realistically priced stock market would be beneficial - something many investors should welcome.

Contrary though it may sound, I do not share the assumption of many City people that a continuation of the current bear trend in the market would necessarily be a disaster. There are several reasons for thinking a return to a more realistically priced stock market would be beneficial - something many investors should welcome.

Although both the US and UK stock markets have fallen sharply from their peaks of around a year ago - the Footsie index has dropped from a peak of around 6,900 to around the 5,500 level - we do not know how much further they still have to fall before this correction phase has run its course.

Despite the best efforts of Alan Greenspan and the Federal Reserve in cutting interest rates, it is not certain these will stop the stock market's current weakness, and the risk of a further fall of at least 20 per cent cannot be ruled out, especially if the US economy has tipped over into recession.

On some valuation measures used by analysts, the market's declines over the past year have taken it out of the "overvalued" category and left it in "fair-value" territory. For example, Barclays Capital's view is that the earnings yield ratio of the US stock market is now approaching levels which, on recent historic standards, would justify saying the market is close to the point where it would normally pay to start buying. The p/e ratio has meanwhile fallen back to around 20 times earnings, which if nothing else looks better than it did at the market peak.

Unfortunately these indicators, though followed by many professional investors, are not theoretically robust and do not provide much comfort this time. Again, taking Barclays Capital figures, the implied future real growth in US corporate profits has fallen from 6.5 per cent at the market's peak to around 4.0 per cent now. This is marginally lower than the 4.2 per cent average growth in real earnings and has actually been achieved since 1960 - but you have to assume in making this calculation that (a) the earnings figures reported by US companies can be relied on (which for several reasons, such as the exclusion of share option costs, must be open to doubt) and (b) there will be no recession, since if there is one it will knock earnings growth down further.

The conventional p/e ratio in the US market, while undoubtedly lower than before, is still above the long-term historical range. And there are plenty of other indicators, such as Tobin's Q, the measure favoured by Andrew Smithers, that suggest the stock market is still significantly overvalued. But none of these valuation measures takes account of the possibility that adverse sentiment will cause the market to overshoot on the way down, just as it overshot on the way up.

Whatever your definition of a real McCoy bear market, it must include a serious shift in sentiment away from optimism to outright gloom. While the backdrop to markets is gloomy, we have yet to see anything to compare with the panic and despair that marks a really bad market - ie 1929 and 1973-74. In contrast to the 1970s, it is still not possible to see where, if anywhere, economic problems of crisis dimensions may be looming.

Nobody knows for sure how seriously any further falls in the US stock market will impact on spending levels and economic activity. Given that investors have been moving into cash and bonds, there is nothing to say Mr Greenspan and other central bankers cannot smooth the way to a more reasonably priced stock market without creating a cataclysmic market collapse. The possibility of a crash remains a possibility, and some return to lower equity market valuations is not only probable, but in many ways desirable. If it can be achieved gradually, so much the better. Analysis by Professor David Wilkie, a leading UK actuary, underlies the extent to which the risk investors face today is primarily valuation-based, rather than economic in nature.

He has broken down the components of equity market returns over the last 30 years, to show how much can be attributed to dividend growth and inflation and also to changes in valuation. The results show that when the UK stock market produced a compound annual rate of return of 12.7 per cent in the 1980s, it was almost entirely due to the 12.2 per cent annual growth in dividends. Dividend yields declined only marginally meaning there was only a modest contribution from investors assigning a higher value to equities in general. In the 1990s, when shares again delivered returns of just over 12 per centper annum, dividend growth contributed less than 3 per cent of those returns (and nothing in real terms). Nearly three-quarters of market returns came from the shift in valuations which saw dividend yields more than halving from 5.8 per cent to 2.6 per cent.

Unless you believe yields can fall by the same proportion again, which is highly unlikely, or that dividend growth can match the 1980s record (ditto), the scope for double digit market returns in the next decade is inevitably constrained by today's high valuation environment.

A period of high stock market valuations is a boon for two social groups: those with earnings linked to market valuations (ie fund managers) and those who have been investing in this revaluation period. There are many others (ie those saving for retirement in 10 to 20 years time) who stand to lose out. Those whose investing life is mostly ahead of them have much to gain from a de-rating of equities.

davisbiz@aol.com

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