Here's hoping there's no nasty surprises in store

Prices are a bit high but given a decent summer and autumn, they should be okay
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The Independent Online
THE LONG Easter weekend break gives a pause for thought about share prices. We are engaged in a European war. The economic indicators for Britain are still fairly weak. The recovery in continental Europe remains patchy. Elsewhere in the world the East Asian economies remain at best fragile. Only the US continues to bound on. Yet share prices on Maundy Thursday were trading at record levels. From the perspective of the financial markets all must be well.

No, not just well - wonderful. In as far as markets can say anything, for they represent, of course, the collective thoughts of a multitude of investors, all with differing views, they are saying something like this. The outlook for both the British economy and the world economy - remember more than half the profits of the Footsie 100 companies come from sales outside Britain - is better than it has been at any stage for at least a generation.

It is not just that share prices are at a record, for you would, of course, expect share prices to rise as the economy grows. The valuations on shares are also at record levels. You can see this in the graphs, which show the value the all-share index has put on stocks since 1963. The price/earnings ratio of nearly 24 compares with an average of 13.7 since 1963 and with a peak of 23 in the 1960s. If you take the dividend yield, the market is now 2.4 per cent, compared with an average of 4.7 per cent and previous troughs at 3 per cent.

The valuations, therefore, are way out of line with the average over the past 35 or so years. How might you justify them? The period that best combines the present experience of low inflation and reasonable growth was the 1960s. The ABN-Amro team which produced these graphs argues that the price/earnings ratio now is similar to - though rather above - the 1960s level.

These are historic levels, comparing share prices with the earnings out- turn. If you take instead prospective p/e ratios, where prices are compared with the expected earnings, the present ratios are around 20. The team reckons that the prospective p/e that can be sustained in the long-term is around 17.

The sustainable dividend yield is put at 3.5 per cent. So until earnings come up a bit - as they may in the second half of this year - share prices do look on the high side, but they don't look absurdly high if economic prospects are indeed as good or better than they were in the 1960s.

There are other ways of valuing shares than the rather old-fashioned p/e ratios and dividend yields. You can for example look at the relationship with bonds and with index-linked gilts. The ABN-Amro team has brought these together into a composite valuation. Its conclusion? That prices are on the high side by historical standards but not at the extreme level they were at last summer.

That would certainly seem a good common sense conclusion. Provided the economy and earnings recover in the second half of this year you can still be reasonably optimistic about the market in the coming months.

So let's accept this as the base position: prices are a bit too high but given a decent summer and autumn they should still be okay. Now let's ask what the surprises might be, starting with the pleasant ones.

SURPRISE number one would be a stronger-than-expected UK recovery in the autumn. To get that you would need rather more confident consumers than we have at present, plus almost certainly a weaker sterling against the euro to boost exports. You would also need sustained demand in the big three Continental markets, particularly in the biggest, Germany - which would be surprise number two.

Surprise number three would be the long-awaited recovery in Japan. The whole of the region, and China in particular, is desperate to see Japanese growth. Question: does the good first quarter performance of the Tokyo stock market, which was up 10.6 per cent in dollar terms, signal the start of a sustained economic recovery? Probably not yet, so it would be a pleasant surprise were it to occur.

Finally, surprise number four would be a continuation of solid US growth but growth associated with a narrowing current account gap rather than a soaring one. Up to now the surprises have been the extraordinary strength of US demand. But the trade imbalances, particularly with Japan and China, are stretching limits of the sustainable. What is needed is sustainable growth, relying not quite so much on the domestic consumer and helped by rising exports.

Now the negative surprises. These are really the mirror-image of the list above. First would come a disappointing UK growth performance this year, still possible but maybe looking a little less likely than it was a month ago. Maybe the relatively optimistic Treasury forecast will turn out right after all.

Surprise two would be a failure of the German economy to stage much of a recovery this year - if the first quarter turns out to be negative the country will have experienced a technical recession. Everyone could live with that provided they could see better times ahead. What they, or rather the markets, would find harder to stomach would be a flat summer and autumn. Germany has grown some of its own problems under the new government, but it is particularly vulnerable to trouble in eastern and central Europe. If Germany fails to recover, France and particularly Italy will have a very difficult autumn.

Problem number three would be a continued downward spiral in Japan, not so much for what that does to Japan itself (though that would be very unpleasant for the Japanese people) but more for what it would do to the fragile recovery now starting in the region. The Japanese influence goes far beyond trading relations, for Japan has extensive investment in local plants, many of which are running far below capacity - it needs an increase in domestic demand to crank up these factories, and hence the local economies.

And finally the US. The single biggest question is not so much the external imbalance, but the extent to which domestic demand has been sustained by the soaring stock market. When Wall Street dips, expect a dip elsewhere. But watch more for the impact on the US economy. The question no-one can know is the extent to which the long boom has been sustained by high share prices - much higher in relative terms than those here.

When valuations are a bit stretched, as they are now, they are obviously more vulnerable to disappointments than they are likely to be affected by the pleasant surprises. Indeed they need the pleasant surprises to support present values. Will they continue to get them? Happy Easter.