Down on the farm with the bulls and bears

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The Independent Online
BULL markets teach investors that what goes down must go up. Bear markets, if that is what we are in, teach them that what goes up must come down. The learning process has only just begun.

For years, every correction has been a buying opportunity. Looking at the chart of the UK market, that could still be true. Yes, the market has fallen more than most, down 12 per cent from its recent high compared with a fall of just over 5 per cent for Continental Europe this year. But if you consider that the UK market has been in a long-term bull trend since the mid-1970s, the recent fall (and for that matter, the crash of 1987) still looks like the curly little tail on the extremity of a huge pig's back.

The bulls argue that UK equities are good value compared with the rest of the world because the UK has growth. And gilts are good value because UK growth is still inflationfree.

The PSBR is on the way down and that leaves more money in institutions to buy equities, as well as reducing the supply of gilts. And the UK corporate sector is now awash with cash and can afford either to invest in productive capacity or to pay more in dividends.

But there are obstacles before the next bull run begins, notably the global liquidity cycle and the valuation of the UK equity market.

Many investors, and certainly bank trading desks (as much as the much-maligned hedge funds) borrowed to buy foreign financial assets on the assumption that US interest rates would not rise and European and Japanese rates could only fall. As soon as US rates went up, the cost of borrowing to invest rose and, because of the virtue of financial engineering, debt costs rose a lot more than interest rates themselves.

That was bad enough. But then the perceived green shoots of recovery in Europe meant that central banks there also kept short-term rates high. That depressed the assets that leveraged investors owned, such as futures on short-term debt, whose value is as much determined by expectations as reality.

Also, rising US interest rates influenced the long bond markets of the world, despite the economic logic that slow-growth Europe and Japan should have bond markets that decouple from fast-growth America. This didn't happen because the gurus forgot one salient point. By the end of 1993, the US investor was pumping, at an annualised rate, about dollars 200bn ( pounds 138bn) into foreign financial markets. Europe (including the UK) received about 70 per cent of these funds, with about a 55/45 split between bonds and equities. Now rising US rates have drastically reduced the flow of funds.

Behind this detail lies a simple fact: the liquidity cycle that drives financial markets anticipates the economic cycle. When economies are on their back, governments throw money at them and people save rather than spend. This combines to create a lot of money chasing a few financial assets. When economies recover, monetary policy tightens, people spend more, and above all, the liquidity that had been sloshing around financial markets finds a job to do in the real economy.

Suddenly there is less money chasing the same financial assets, and ironically, it points to another home truth: that a bit less growth, particularly in the US, would be bullish for bond and equity markets. To paraphrase Animal Farm: good growth is bad; and bad growth, good] As long as the dials are turning to optimism about world growth, we can expect good performance out of real assets like commodities, which get repriced as output strengthens, and bad performance from equities and bonds.

Bonds will always do badly when economies recover because inflation ticks up and bonds, being fixed-income-stream instruments to the investor, do not participate in recovery in profits and dividends. The negative case for equities in an economic recovery is much more ambiguous than for bonds. For equities it depends on valuation. If equity markets anticipate the full strength of earnings recovery before rising interest rates happen, then economic recovery and a waning liquidity cycle will be as bad for equities as for bonds.

That is probably the case for the UK. The UK equity market sells at 130 per cent of its 10-year average for three vital ratios: price to cash earnings, price to earnings, and price to book value. And dividend yields are 13 per cent below their 10-year average. So UK Inc had better use its new-found cash surplus to boost dividends - or else]

Current valuations anticipate a substantial amount of the recovery already, leaving the market vulnerable to rising interest rates, because this is the only criterion by which UK equities still appear reasonable value. In a market like this, stick to cyclical and retail stocks and stay well away from financials, because the latter are the ultimate victims of the end of the liquidity cycle.