Correction, or a darker beast at work?

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In March of last year, I wrote about the case for a continuing bull market. At the time, the FTA All-Share index stood at 1,437; by the end of the year it had risen to 1,682.

On 6 January this year, I suggested playing cautious in UK equities and holding 15 per cent in cash. In February, after the first up-tick in American interest rates, I suggested weeding out doubtful stocks to increase the cash content of your portfolio to 25 per cent. The FTA All-Share index peaked at 1,764 on 2 February and has since fallen by about 10 per cent to 1,581.

There is no doubt that it is very hard to make money in a bear market. For example, shares of shells that are usually so full of hope are soon looked at in a very different light. Instead of believing that the new management is going to make lots of attractive acquisitions and work wonders for the company, the emphasis switches to the poor underlying asset value, high gearing and the difficulty of underwriting shares to finance expansion.

Similarly, in a bull market, investors in a biotech stock might be hoping for a new drug to be developed and marketed throughout the world. In a bear market, the emphasis might switch to the fear of further delays in bringing the new drug on-stream and obtaining the necessary approvals. This could in turn result in the company running out of money, followed by yet another rights issue.

At the moment, the market may be simply undergoing a major correction or it could be in the early stages of a fully-fledged bear market. When Peter Lynch was interviewed by Barron's in late April, he explained that in this century there have been 50 American stock market declines of 10 per cent or more, of which 15 were 25 per cent or more. On average, therefore, every two years there is an American market correction of about 10 per cent, and every six years a bear market with a decline of at least 25 per cent. We usually follow America.

From the February peak, the UK market has had a 10 per cent correction already, so the key question is whether or not it will now extend into a bear market. Mr Lynch lays no claim to knowing the future direction of the Dow, but he does say that he can now find many more American shares that satisfy his criteria. He continues to believe that long term the stock market will remain one of the best mediums of investment. Certainly in this country, the 12 per cent overall return from the average share during the past 75 years evidences this point. Mr Lynch goes on to suggest that private investors should ask themselves if they are going to cash out or weather the storm, which may or may not materialise. I particularly like his concluding comment: 'The brain isn't the most important organ here, it's the stomach.'

The key point to remember is that, even if we are in a bear market, shares do not go down evenly across the board. In the early stages, bear markets can be very discriminating and selective; they cull the herd efficiently and decimate the prices of shares based on excessive hopes and extravagant promises. The kind of growth company that is likely to survive the bear market or the correction, with both its share price and the company itself remaining in good shape, is likely to possess these important characteristics today:

1. Earnings per share that have grown recently at an above-average rate and are reliably forecast to continue to do so.

2. A prospective price-earnings ratio that is below average in relation to the growth rate.

3. Strong cash flow with a sound balance sheet.

It goes without saying that businesses possessing these characteristics tend to have good management and some kind of competitive advantage. How else could they continue to produce profits increasing at an above-average rate?

I am encouraged to see that companies which are reporting better than expected figures are performing relatively well in the market. Electron House, for example, which I recommended at 118p in September, has just reported that sales for the current year will be up from pounds 78.4m to over pounds 100m, there will be no debt in the May 1994 balance sheet and earnings per share will be in excess of current expectations. The shares responded well with a rise to 152p.

BP shares have also responded well to the vastly better results, increased dividend and improved prospects. So have the shares of Next and Psion, and I have no doubt that there will be a sprinkling of other companies that will continue to show good relative strength even in the most difficult market conditions.

No one knows the future direction of the market. A significant unknown is whether or not rising interest rates and falling share prices will provoke investors in American mutual funds to become net sellers, reversing the massive flow of money into world equities.

Value is beginning to creep back into the UK market - the average prospective price-earnings ratio is about 15 and the average dividend yield is 3.7 per cent. The trouble with value as an immediate measure is that market prices swing like a pendulum from over-valuation to under-valuation - and we may now be heading in the latter direction. However, it is always comforting to know that value comes into its own eventually, so in a falling market the adage 'selection is more important than timing' is truer than ever.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. He has agreed not to deal in a share within six weeks before and after any mention in this column.