MARKET OUTLOOK: Forecasters wary after slump of '94

After last year's misplaced optimism, the City's equity strategists are playing safer this time, with most forecasters predicting rises for the FT-SE 100 index of little more than about 10 per cent.

The confusion caused by 1994's unexpected 9 per cent slump in the Footsie, however, is underlined by the wide range of predictions, which range from James Capel's relatively bullish 3,700 to Panmure Gordon's perenially gloomy expectation of further fallsto 2,800. The most popular target is 3,500, with Warburg, Morgan Stanley, BZW, Kleinwort Benson, Hoare Govett and Smith New Court signing up for that level.

Nick Knight of Nomura, previously a market super-bull, changes his tune this year with a relatively modest 3,200.

Capel thinks total returns from shares this year, including dividend income of more than 5 per cent, will be more than 25 per cent. That should compare handsomely with the returns from bonds and cash of 8.8 per cent and 7.5 per cent respectively.

Stewart Breed at the broker admits that Capel got it wrong last year but for the right reasons. At the beginning of 1994 it was predicting that strong earnings growth would drive the market higher.

Earnings did grow very strongly, by 32 per cent on average for the FT-SE 100 stocks, but Capel had not counted on the rout of the gilts market in the first six months of the year, as rising US interest rates drove yields higher around the world.

According to Mr Breed, that lowered the price investors were prepared to pay for shares' earnings and the market's price/earnings ratio fell during the year from a high of almost 26 to 17, wiping out the effect of higher profits.

That derating has been overdone, Capel says, and part of its forecast includes a small bounce in the p/e. The greater part, however, is expected to result from a further 17 per cent rise in average corporate earnings.

If bonds recover, equities are expected to match any rise in fixed-interest instruments, but Capel's forecast does not count on any improvement.

NatWest Securities also believes that shares will hit new highs in 1995 but cautions that towards the end of the year political worries will drag shares back again, limiting the year-end result to about 3,400.

Looking further forward, however, NatWest thinks the Footsie will reach 4,400 by the end of the decade, giving average returns on shares of 12 per cent, a bit higher than the 10 per cent expected from bonds.

The basis for its relatively bright investment picture for the rest of the 1990s is the belief that Britain has made a radical break with the post-war experience of high inflation, uninspiring GDP growth and continued problems with public sector financesand the balance of payments.

If Britain really has made the break, NatWest thinks companies will be able to lift profits at around 8 per cent a year, with dividends growing broadly in line with the economy.

Both brokers are concentrating recommendations on manufacturers rather than consumer stocks, although Capel also thinks that some volume-related consumer cyclical areas such as leisure will benefit.

With the legacy of the late 1980s investment boom, many companies find themselves able to reduce labour without reducing their ability to meet demand. There has been a structural shift in productivity.

Because of that, volume-sensitive companies will see relatively higher earnings growth in this economic upturn than last time.

Sectors expected to underperform next year include property, where rental growth remains elusive, extractive industries, where recent commodity price rises are thought to have run ahead of economic growth, and engineering vehicles, where last year's recovery in European car sales is already firmly in the price.

Next year's winners could come from the oil sector, where the oil price is expected to have another good year, diversified industrials (the old conglomerates) where order books are strong, and the drinks industry, where earnings are expected to grow strongly in 1996.

The pharmaceuticals sector could do well, with shares trading on market multiples and sporting higher yields than the market as a whole. Cash-generative media companies such as Reuters, Reed and Emap are also favoured