Outlook: Dow madness

WHEN IT comes to stock market investment, there is rarely any such thing as an independent view. Thus we had two very different perspectives on soaraway US stock markets this week. Katherine Garrett-Cox, head of American equities at Hill Samuel Asset Management, is still a raging bull, but then she would be. Her funds are reported as being the best performing in the UK over the last twelve months. If Wall Street goes pear shaped, she'll be among the worst performing in the next.

Meanwhile, Bill Martin, head of research at Phillips & Drew, says in a research paper that Wall Street is more than 60 per cent overvalued, and by implication, heading for a nasty fall. Again, he would do, for that has been pretty much the house view these past three years. P & D has to justify its failure to thunder with the herd somehow or other.

Of the two, however, it is the Bill Martin analysis which is the more compelling. The overvaluation figure is arrived at using fundamental stock market analysis techniques, the detail of which need not bother us here. But essentially it comes down to the common sense observation that the market has overperformed its long term trend for some considerable length of time now. Past points of abnormal overvaluation have nearly always been followed by periods of sub normal stock market returns.

What Mr Martin refers to, perhaps predictably, as "today's bubble", is the biggest such valuation anomaly identified by these methods in the post-war era.

Investors are on the whole a sophisticated lot, and they are just as capable of seeing these things as Mr Martin. So why do they continue to ignore the warnings? P & D suggests complacency brought on by two things. First is belief in the new economy - the idea that America has entered a new and sustainable era of steady, inflation free expansion. In other words, investors believe that this time round it really is different.

Second is the belief that the Federal Reserve will underwrite the stock market through interest rate policy.

Alan Greenspan rode to the rescue when things looked rocky last Autumn, so presumably he'll do it again. Mr Martin believes that neither of the these things would survive the prolonged period of economic weakness that would follow a reversion to more normal private savings behaviour.

This may be true enough, but actually one of the reasons why Americans aren't saving is because the stock market keeps rising, which makes them feel wealthier and obviates the need for saving. A return to more normal saving habits probably requires the stock market to fall first.

Nor does Mr Martin address the obvious point that so long as Americans continue to believe in the new economy and the safety net of the Fed, the stock market will continue to gain support, however misguided they might be. The more interesting question, then, is what might puncture these beliefs. There's nothing obvious on the horizon, but as this column has said before, a resurgence of inflationary pressures leading to a rise in interest rates continues to be the most likely cause.

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