Cracks in confidence will be slow but sure

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The Independent Online
How long can the boom in London securities prices continue? It has been a successful year for financial markets in general, and London has been no exception. The run in both bonds and equities in the last few days before Christmas gave a total return this year of more than 25 per cent from equities and more than 20 per cent from gilts.

In world terms this puts the UK in the middle of the pack. Looking at equities, the highest returns have come from two markets in East Asia: Hong Kong and Malaysia, which have moved upwards in almost a straight line, just about doubling over the year. Thailand, Malaysia and Taiwan have also performed well, as have most of the Continental European markets. But the two largest markets have underperformed: the Dow Jones industrial index in the US has risen modestly from the 3,300 region to around 3,750, but the Nikkei-Dow in Tokyo started the year at 17,000, is back there now and is theatening to fall further. The whole Japanese financial system is quite precarious.

But that is history. What next? There are two views about securities prices in the coming year. The mainstream view, held by virtually all the professional advisers in the securities houses and the big fund managers, is that at least as far as the British markets are concerned, there will be another year of high returns. The minority view, held by a very small number of 'boutique' advisers and a few small fund managers, is that the risks for investors in the coming year are greater than the rewards and that it will be one of those times when they should seek to preserve value rather than attempt to increase it.

One of these views is wrong, but which? Take an example of each, and see which sounds more credible. Perhaps the best analysis of the 'conventional' view comes from David Walton, Sushil Wadhwani and Mushtaq Shah at Goldman Sachs. In a nutshell, their argument is that the UK is still in the early stages of an economic upswing and there should be a couple of years of steady, non- inflationary economic growth. Low inflation should allow gilt yields to fall further, with the return on 10-year gilts dipping below 6 per cent in the next few months. Goldman estimates that the capital gain from this fall in yields, coupled naturally with the interest, should give a total return of up to 15 per cent.

As for equities, Goldman believes they are still undervalued. It has what it calls a composite valuation indicator. This looks at the return on equities in relation to that on bonds and cash, and at profit growth next year, all of which make equities look cheap. It then allows for the historically high price/earnings ratios at present which make them look dear. Goldman's conclusion it that on balance UK shares are undervalued by 19 per cent. It does not expect the market suddenly to shoot up by that amount, but looks for the FT 100 share index rising to about 3,750 by the end of the coming year, giving a total return of around 15 per cent. Of this, much will come in January - the 'January effect'.

Goldman does draw attention to some risks. For gilts the principal risk is that in the second half of the year worries about inflation may start to surface. For equities, the main risk is a downturn in the (more highly rated) US market.

Goldman believes that the UK market could still move ahead even if US share prices turned down, and cites periods in the past where the two markets have diverged. But it acknowledges the risk.

Still, it is an optimistic outlook in the sense that expected returns will be significantly higher than the 5 per cent or so obtainable from cash. For the pessimistic outlook, which essentially suggests that this year money should be kept on deposit, look at the work of the investment advisers, Smithers and Co, run by Andrew Smithers. This is a boutique, based in London, which specialises in analysis of the two biggest markets, the US and Japan. In that sense its comments are not directly comparable to those of Goldman: instead of starting with the British market and then seeing what might affect it from abroad, it looks at the US market and draws international investment conclusions from that. But the interesting thing it that its tone and assumptions are utterly different. Its latest report on the US market, by Stephen Wright, is called 'Investment Stategy in the Bear Market'.

The Smithers case is that the long bull market in US equities is over. While over a very long period, from the mid-1920s, equities have given a higher return than either cash or bonds, that return depends on the first long bull market of the 1940s, 1950s and 1960s. Otherwise, the long-term return on equities has been unimpressive. The last bull market has brought the price/earnings ratio in the US to record levels, and at some stage the ratio will head back to more normal regions. Markets expect a benign adjustment, where rising profits gradually pull back the ratio without any collapse in share prices. The Smithers argument is that this is most unlikely as it has never happened before.

Its conclusion is that there will be unpleasant surprises. The safest holding will be cash, rather than bonds, for it reckons bonds, including gilts, are overvalued given inflationary expectations for the next 10 years. It notes that the highest returns on the period from 1969 to 1981 came from cash. This issue then is what currency the cash should be in, and here Smithers suggest dollars, for the revaluation of the dollar is not yet complete.

So, two very different perceptions of the world, with very different investment conclusions. My own view is that at some stage quite soon the appropriate investment strategy will indeed move from adding to wealth to preserving it. Accordingly, the 'play safe' strategy is the wiser one. But there may be several more months of strong bond and share performance before the markets turn down, so anyone who does bale out now may feel disappointed for some time. By the end of next year, though, it would be surprising if the cracks in investor confidence are not evident.