The broker said the high level of director buying was only one of several indicators pointing to a continuation of the bull market, despite a separate prediction that inflation would rise to 4 per cent in 1999 and interest rates reach 8 per cent by the end of next year.
Speaking at a global strategy conference in London yesterday, Philip Wolstencroft, UK equity strategist, said institutional investors' historically high cash positions and a slump in the supply of new shares on to the market painted a bullish picture for the stock market.
He contrasted London with the US equity market, where shares are more highly priced compared to bonds than for six years, directors are strong sellers of shares in their own companies and market sentiment is unduly bullish.
During August, UK directors buying shares in their own companies exceeded sellers by a ratio of 3.6 to one. That was the highest since 1992, when shares were at historically low levels thanks to the high interest rates prevailing in the run-up to the pound's ejection from the exchange rate mechanism.
According to Merrill Lynch, the ratio of buyers to sellers exceeds 2.5 relatively rarely. Since 1986, it has happened only 17 times but on 16 of those occasions shares have subsequently outperformed cash over the following 12 months. The average outperformance was 15 per cent.
One of the reasons for the strong buying has been the relative underperformance of large sections of the stock market, which has been driven by a very narrow cross-section of companies. Stripping out the banks, pharmaceuticals and oil companies, which have risen in value by almost 60 per cent since the beginning of 1996, the rest of the FTSE 100 has risen by less than 20 per cent. The FTSE 250 index of second-liners has fared even less well.
Merrill Lynch is maintaining a bullish stance despite the expectation of Paul Turnbull, its UK economist, that inflation will continue to rise over the next two years, driven by a rapid tightening in the labour market and accelerating earnings.
Unemployment is expected to fall to 1.25 million by the end of 1998. According to Mr Turnbull, that will push growth in average earnings from 4.25 per cent in June to 5.5 per cent by the second half of next year.