The Jonathan Davis column; Bulls should be haunted by bears of the past

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The Independent Online
Most investors with sense are in the stock market for the long haul and treat short-term speculative gains as an unexpected bonus, rather than necessarily as confirmation of their acute insights into the market. Taking a long-term view has the merit of being a respectable as well as a thoroughly sensible approach for anyone who can afford to wait and see how life turns out in 10-15 years time.

But how long is the long term - and what sort of perspective should one take in trying to assess the current level of risk in market valuations? In recent columns, I have used two illustrations - one showing Tobin's so-called q ratio and another valuation work carried out by Barclays Capital - which trace the market's performance back to the end of the First World War. On both measures, stock markets world-wide can be seen to be at or near the top of their historical trading ranges.

The reasons for this are explicable in terms of short-term economic prospects - low inflation, falling long-term interest rates, resilient growth, a rapid rate of technological change, and so on. The issue for investors is whether current market prices fully reflect the risk that the future will turn out to be, as so often in the past, less benign than market ratings currently assume. The smart money, I conclude, inclines towards not having too high expectations of future equity market returns.

But what if one takes an even longer historical perspective? This week, I have been looking at the work of a market analyst whose take on the level of the market dates back to the 18th century, and whose gloomy prognosis about the marketsmakes my caution, and that of other even better qualified market investors, sound like rank timidity. Robert Prechter is a well-known market punter in the United States. His greatest claim to fame is that, as long ago as the early 1980s, he predicted we were about to experience a "bull market of a lifetime".

He was right, of course, though it took him some time to realise how far that would take the stock market; his initial forecast was the Dow Jones Index, then trading around 800, would reach 3,700. He has subsequently raised the limit more than once, but even his enthusiasm (accompanied by intermittent bursts of gloom) has not been enough to keep pace with the actual performance of the US stock market, which this week reached a new, all-time peak of 8,583 for the first time.

Mr Prechter is a technical analyst, who bases his forecasts on the so- called Elliott Wave Theory, devised by a former naval engineer 40 years ago. His premise was that the cyclical behaviour of financial markets might appear random but in fact follow long-term patterns of boom and bust, which stretch across generations and oceans, in waves which contain predictive power.

Mr Prechter has hundreds of charts, like the one I show, which attempt to map the long-run historical behaviour of the markets back to the South Sea Bubble, and forward to the end of the next century. Leaving aside for the moment the reliability of such charts are (the data for the 18th and 19th centuries are a mixture of London and New York prices of uncertain reliability) and the credibility of the theory. What does Mr Prechter think now?

Well, he thinks the bull market is in its last throes. Not only that. We are poised, he says, on the edge of a bear market, and it won't be any old bear market either. This one stands to be Wave Five of a "Grand Supercycle" bear market, the last throw of a cycle which began way back in the 1700s. A "Grand Supercycle bear market", you should know, is about as bad as it gets in Elliott Wave Theory.

In fact, Mr Prechter says, he doesn't expect the bear market to stop until the Dow Jones has fallen all the way back to 1,000, a fall of around 85 per cent from current levels. This will probably happen around the year 2003 and be accompanied by a severe economic depression. After that, look out for bull markets which peak in the 2020s and another one (assuming you are still around to notice) in the 2050s.

Mr Prechter has a lot of advice on how to cope with this new era, such as "obtain a residence in an area which is unlikely to be the target of mob violence or looting" - all of which begs the question of whether there is anything in the premise in the first place.

Personally, I have no hesitation in saying that Elliott Wave Theory is a load of tosh. There is no basis in social science for believing that financial markets should follow succeeding wave patterns in a predictable fashion, even if the underlying data were statistically robust (which it clearly is not). An unkind critic might also point out that Mr Prechter's timing is far from perfect. He was forecasting the start of "the Great Supercycle bear market" at least three years ago, since when Wall Street has risen by over 40 per cent.

Surprisingly, perhaps, a lot of well-respected American investors are happy to say that they listen to what Mr Prechter has to say, even if (they tend to add) they don't agree with him. It is not actually hard to see why. Like a lot of technical analysis, many of Mr Prechter's charts are fascinating. Some of his comments on the manifestations of bull market psychology are well made and acute. The charts of market movements clearly contain information: the problem is interpreting them.

Ultimately, his charts do tell us something important about the state of the markets. Unfortunately, it is probably nothing more profound than what goes up does also come down. You can be certain that the current bull market in shares will end one day, and we will have a bear market - probably sooner rather than later. Not the least burden of that will be listening to Mr Prechter telling us how he had told so before if only we had bothered to listen.

`Money Makers' by Jonathan Davis, a study of Britain's most successful professional investors, has just been published by Orion Business Books at pounds 20. To order a copy, at the specially discounted price of pounds 15 (including postage and package) call 01903 736736, quoting the reference MMJD.