Expectations are heavily influenced by recent experience. People are therefore usually surprised when things change.The ideal background for a rising stock market is an economy that is picking up and in which shares are cheap because expectations are moderate. This is a world inhabited by bears sitting on piles of cash. When things turn out better than expected, they put first toes and then whole paws into the market. Share prices rise and the gloom disappears.
In the opposite world of fully invested bulls, euphoria is at first rampant, but the mood changes via disappointment to despair. The general mood is still pretty euphoric in the US, but it is clearly more sombre here. The difference is partly national temperament and partly that in the UK the beginnings of recession are already visible.
Both stock markets are selling at high p/e ratios - which are 50 to 100 per cent above normal - and profits have begun to fall on both sides of the Atlantic. Fund managers might be expected to sell in the face of this discouraging combination.
It would be different if profits were already depressed. When things are really bad, multiples are high because profits are so low. For example, p/e multiples had to be very high in 1932 because most companies were making losses. None the less it was a wonderful buying opportunity, just as 1929, when profits were high, was a wonderful moment to sell.
Fund managers, however, are not selling - though not because they are caught up in the general euphoria. Most are well aware that stock markets are wildly overvalued, but they also know share prices can stay too high for a long time. They are therefore nervous of going liquid. This is very reasonable. Even if they know the stock market has a 70 per cent chance of falling over the next 12 months, going liquid means a 30 per cent chance of them losing their jobs. Staying invested, on the other hand, seems the safe course for fund managers, though not of course for their clients.
If managers never go liquid, there is no reason to expect markets to fall unless investors run out of money. Once markets fall, of course, it will be different: being fully invested will cease to be fashionable. But while fashion will reinforce a change, it is unlikely to instigate it. The investors most likely to run out of money are companies themselves. This is particularly true in the US, where companies are far and away the largest buyers of shares.
The popular image of the recent bull market in the US has been one where investors have piled money into mutual funds, driving the market to ever higher levels. But this is not what the official statistics show. According to those published by the Federal Reserve, individuals have been selling more and more shares each year and selling far more directly through the stock market than they buy indirectly through mutual funds.
As the chart below shows, the US stock market has become increasingly dependent on companies either buying their own shares or buying other companies through take-over bids.
Managements have become more and more dependent on stock options, which constitute an ever-growing part of their total remuneration. According to Pearl Meyer & Co, a remuneration consultancy, 13 per cent of the shares of US companies are now earmarked for these programmes and the percentage is still rising. In these circumstances, managements will want to keep buying shares provided they can find the money.
Here lies the problem. The retained profits of US non-financial businesses are currently running at only half the level at which companies are buying shares. The net worth of US corporations is thus falling, while their debts are rising - a process which cannot continue for long and which is likely to come to an abrupt halt on any serious downturn in profits.
So far this hasn't happened. Profits have gone down since they peaked in late 1997, but up until now the decline has been modest. However, the IMF expects US growth to halve to only 1.8 per cent in 1999, and if it is right, the fall in profits will accelerate sharply.
Wall Street appears, therefore, to be betting that the IMF will be wrong. In practice it is probably doing no such thing. If, as seems to be the case, fund managers are too frightened to try and forecast stock markets, then stock markets will not respond to the prospect of falling profits, only to the fact. It is likely that share prices recovered over the past few months simply in response to the fact that companies have bought so many shares. If profits fall sharply, this buying will slow if not stop and the stock market will tumble.
In fact, the IMF's forecast of 1.8 per cent growth for 1999 seems improbable, but the risk is that it will be worse rather than better.
If growth slows as much as the IMF expects, the decline is likely to accelerate. The problem is the stock market bubble, which has pushed household savings in the US to less than nothing. Americans now spend more than their incomes and seem to consider that saving is for wimps. Once the economy starts to slow down, profits will fall sharply and it will be most unlikely that the stock market will not come down as well. When this happens, people will feel the need to start saving again. As investment will also fall off sharply, jobs will be harder to get and this will also make people more cautious.
With the stock market so high and savings so low, the US economy is extremely fragile.
Andrew Smithers runs Smithers & Co, the fund management consultancy.Reuse content