Just a one-day wonder, but fears of a real crash remain

Click to follow
The Independent Online
It was a one-day wonder, the mini-crash triggered by Alan Greenspan on Friday. And even so, the markets overreacted to the Federal Reserve chairman's disapproving comments about their "irrational exuberance", according to another central bank governor, the Bank of England's Eddie George.

Yet the sudden dive in share prices around the globe did once again highlight fears that Wall Street was overvalued and headed for a crash. Investors can be excused for being confused. There is a clear division of opinion among the gurus about whether shares are poised for a 1987-style tumble or whether the great bull market can continue.

In the gloomy camp are analysts who focus on a range of indicators of the underlying value of shares.

Most of these show that equity prices in the US are far higher than their long-run relationships to other assets would justify.

Perhaps the most startling is that the stock market capitalisation of American companies is nearly the same as the country's gross domestic product, according to calculations by Jim Bianco at Arbor Trading. The normal ratio to GDP would be less than 50 per cent.

Andrew Smithers, of Smithers & Co in London, puts the emphasis on "Tobin's q", the ratio of stock market value to the actual value of the underlying assets. Anything higher than one would point to shares getting out of line, but the ratio currently stands at 1.5, or more than two times its historical average.

The more conventional measures of whether shares are overvalued, the dividend yield and price-earnings ratio, are sending a similar signal. A measure of whether returns on equities are out of line with the yield on long-term bonds, the dividend yield on the S&P 500 index is just above 2 per cent, about half its average and below the 1987 level. The ratio of share prices to corporate earnings, at around 23, is below its then- high of 25, but possibly not far enough below.

Mr Smithers says: "Why does anybody doubt all of this evidence? People are anxious to sell at the top, but nobody can possibly tell when that will be." Arguments that do not take account of all these stretched ratios are not rigorous, he charges.

The optimistic case rests on the view that the numbers do not tell the whole story because market fundamentals have changed since 1987. For example, Abby Cohen, equity strategist at Goldman Sachs in New York, believes that a higher p/e ratio is warranted in an era of low inflation. Current low levels of US inflation have in the past been associated with ratios of 18-20, she calculates, because investors are willing to pay more for a certain level of earnings when inflation is expected to remain low.

David Shaw, at investment giant Legal & General in London, backs this argument, noting that the trend rate of productivity growth has increased. This should mean healthy corporate profits growth over a sustained period.

Luckily for London, nobody believes shares on this side of the Atlantic are overvalued at all. London has underperformed other stock markets for the past three years.

According to Richard Davidson, the UK strategist at investment bank Morgan Stanley, this down-rating has been due to the fear of higher inflation and political uncertainty. He says: "People have been ignoring the potential profits growth," and predicts that London will outperform other markets in what promises to be a turbulent 1997.

Mr Davidson reckons that, on all the conventional ratios, UK shares will look very good value next year, with a p/e ratio of 12.5 compared with 17.9 for the US, for example. He adds that London tends to share in big Wall Street crashes, but can escape smaller corrections.