How long before the Wall Street party's over?

They talk of Beethoven and Dylan Thomas, but analysts cannot agree about prospects. David Usborne reports
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The Independent Online
Last week gave us the twilight days of stock trading between Christmas and the start proper of the new year; on Wall Street, at least, they amounted to a gigantic tease. Anyone straining to see omens for 1997 on this side of the puddle should have turned off their screens.

On New Year's Eve, the Dow Jones Industrial Average seemed clearly to signal trouble ahead when it swooned by some 101 points. But, lo and behold, last Friday it delivered one of its miraculous mini-surges (actually, it was the Dow's sixth-biggest one-day gain in point terms) rising by 101 points. All said and done, it ended the week down by a mere 16.82 points.

The questions, of course, are these: can American stocks possibly sustain their run of the last two years? Or should investors be prepared to be humbled in 1997 with a correction - if not to say crash - that some believe simply has to happen? How bad might it be?

Consider the sheer chutzpah of American stocks. Last year, the industrial average gained a mighty 26 per cent in value, shaking off a couple of nervous episodes in July and October. That came on top of the still more impressive 33.5 per cent increase achieved in 1995. When the ball dropped on Times Square last Tuesday night, the Dow stood a full 68 per cent above its close at the end of 1994.

If we must try to predict the months ahead (and, of course, we must), there is a relatively easy route: you look at the American economy for a moment and conclude that there is nothing compelling out there that suggests disaster. Indeed, the Federal Reserve and its chairman, Alan Greenspan, could have found the magic monetary formula: inflation is at bay and so is unemployment. It is worth remembering that the Fed's Open Market Committee has not done a thing to interest rates for almost 12 months.

There is even the theory about that the economic cycle of boom and bust has actually been tamed and the picture ahead is one of steady, low-inflation growth. That was the view expressed in a recent survey by the Washington- based National Association of Business Economists.

"While all business cycles eventually end, almost all of the 44 economists who responded to the survey expect economic expansion to continue for the foreseeable future," the association said. "That conclusion may not be precisely what Ludwig van Beethoven had in mind in his cantata 'Calm Sea and Prosperous Voyage,' but the approximation appears to be close."

From Beethoven to Dylan Thomas. It is to the Welshman and his great poem Fern Hill that Barton Biggs, the strategy guru of Morgan Stanley, reaches when trying to describe the heady mood of 1996 in a New Year's essay to his clients.

"Now as I was young and easy under the apple boughs / About the lilting house and happy as the grass was green, / The night above the dingle starry..." And the second verse begins: "And as I was green and carefree, famous among the barns..."

But wait. Mr Biggs is among those noting that paradise is never for ever. He offers: "I don't think that 1997 is going to be as golden or that we are going to be as 'green and carefree'. The market may wipe that smile off our faces. Something bad is going to happen. It's just a question of how bad."

Mr Biggs concedes his prediction is based principally on hunch, instinct and an awareness of history. He points out that in 65 of the first 95 years of this century, stocks in the US declined by at least 10 per cent. He adds even more ominously that in this century crashes of 40 per cent or more have occurred once every 8.7 years.

He concludes: "I think that in 1997, we will experience a true bear market in US stocks for the first time since 1990. My guess is that this bear will be of the cyclical variety, with a decline of 20 per cent to 30 per cent peak to trough, that will last about six months."

And Mr Biggs is acting accordingly. He has taken the cash share of his model portfolio from zero to 15 per cent and is selling US stocks. David Shulman of Salomon Brothers has gone further, raising cash to 20 per cent of his model portfolio.

History and superstition apart, there are reasons to worry about the US market. However ideal the economic and political environment in the US may be - the famous Goldilocks scenario - there has to be a limit to the market's ascent before valuations are stretched beyond the bounds of credibility and the whole edifice crashes.

We know Mr Greenspan is worried because of his remarks just before Christmas about "irrational exuberance" among US investors. The intimation was that a bubble had grown on Wall Street that could burst at any time with potentially horrible consequences, just as the Japanese bubble did in 1989.

Here, it is worth giving close scrutiny to the role of the US mutual fund. In 1996, investors poured a stunning $208bn (pounds 123bn) into mutual funds - the equivalent of unit trusts - shattering the previous record of $129.6bn set in 1993. They did so on the clear understanding that their money would be put to work instantly in equities.

Fund managers acted accordingly, cutting the funds' mean holdings in cash in 1996 to just 6.2 per cent of assets - the lowest level since 1977. And, of course, as managers scoured the equity market for vessels for their torrents of dollars, so they helped drive the Dow still higher and higher.

Such is the pressure on managers to keep their funds among the top performers, many may be closing their eyes to the risks that they know lurk in the markets. It is the case of Robert Marcin, whose predicament was highlighted recently by the Wall Street Journal.

As manager of the $2.3bn MAS Funds Value Portfolio, he admitted to "bending" his own investment rules in continuing to dive into the Dow to pump up his returns. All the while, however, he has been adjusting his own personal portfolio by cutting back on US equities and preparing a possible return of the bears.

If it is blind faith that is making US investors give so much of their wealth to the equity market, then there is reason to fear. An unexpected and reasonably sustained downturn in the Dow could trigger an equally irrational loss of faith and a panic of mutual fund redemptions. The downturn could then become a spiral.

On the other hand, we could be at 7,000 over here by March.