Farrell rings New York alarm bell; The Investment Column

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The Independent Online
Fund managers who are nervous about the prospects for the US market this year will draw inspiration from the thoughts of Robert Farrell, the widely respected investment adviser to Merrill Lynch. In London yesterday to address the UK investment community, Mr Farrell is unrelentingly bearish about the prospects for US shares, predicting a 25 to 30 per cent correction in the soaring New York market in 1997.

He reckons investors will get a foretaste of what is in store in a fast- approaching "interim peak" for large capitalisation stocks, which have led the 33 per cent advance in the Dow Jones Industrials index over the past year. But he suggests the final top could come with earnings disappointments later in the year.

He does not have to look far to support these gloomy predictions. Two key investment yardsticks stand out. The average dividend yield on American shares has hit a historic low of just 2 per cent, while the price/earnings multiple for the smaller capitalisation Nasdaq market has reached a gravity- defying 49.6.

Those two factors alone should set alarm bells ringing, but Mr Farrell points to the equally worrying spirit of euphoria sweeping Wall Street. Instead of paying down debt or making higher payments to shareholders, company managements are using excess cash to buy back shares, which boosts the value of the share options they grant themselves instead of salaries. The increasing value of shares means companies are financing record takeover activity, topping $600bn last year, by issuing paper rather than paying cash.

The obverse of this phenomenon is that when share prices turn down, companies' impoverished balance sheets could be left exposed while managements' motivation will take a dive.

The problems do not just lie with the "real" economy and companies. US stock markets are also crashing through the record book, with New York share volumes hitting new highs in the first half of 1996 and new issues also at a new high. The burst of speculation in small capitalisation stocks which peaked halfway through 1996 usually sees larger companies following suit some six to seven months later, Mr Farrell claims, pointing to his "interim peak" in the Dow any time now.

Among the many pointers to 1997 being a down year, he highlights the unerring record of market declines when the first post-election year is the seventh in the decade. The record $1.45m paid for a seat on the New York Stock Exchange is another.

But the massive flow of money into mutual funds, the US equivalent of unit trusts, looks a more solidly-based indicator of trouble in store (see chart). The only consolation for investors is that Mr Farrell reckons this year will be a four-year cyclical low, rather than the major bear market which occurs every 20 to 25 years.