The reluctant bulls

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The Independent Online
If the recession is over why are shares not booming? The City was in cautious mood yesterday and not just because of the bomb - to which, it should be said, it has made a quite astonishingly ordered and professional response.

While the foreign exchanges have taken the increasing evidence that the UK recovery is secure as a sign to buy sterling, the equity market was quite sober. This demands an explanation, for while on some historical measures UK shares are overvalued at present prices, they are certainly undervalued when compared with most other equity markets. Business leaders are saying that they expect even better things to come, witness the Institute of Directors' latest survey of members. Yet the market seems reluctant to believe them.

Part of the explanation lies in the fact that roughly half the income of the large companies that make up the FT-SE 100 share index comes from abroad, so that mathematically a rise in the pound should be bad for the earnings of those companies. Another part lies in the eagerness of equity markets to look ahead - everyone assumed that the recession's end would be formally declared yesterday, so the news had been discounted. (It is curious that the foreign exchanges, for all their sophistication, find it harder to anticipate the news than do the equity markets).

But this is not all. There are several other reasons for caution which have been 'in the market' now for a month or so, and constructing a bull case for equities means demolishing these. They include: the possibly overvalued base from which we are starting; the danger of a Wall Street crash; the Continental recession; and the danger of rising inflation and interest rates in the UK.

Whether UK shares are overvalued or not is one of the issues tackled in the latest investment strategy paper from the brokers Smith New Court. The central issue here is whether one takes price/earnings ratios as the principal indicator of value, or whether in a low inflation environment these are less important than other indicators.

The present p/e of around 17 for non-oil UK industrial stocks has been exceeded during only three periods since 1964: in 1967 after the Wilson devaluation, in 1971 before the Heath boom took off, and in 1987 before the share crash. One could draw two conclusions from this: one would be that there is a danger of a 1987-style crash, the other that the 1960s were a period of similar levels of inflation to the present and by those standards the present p/e ratios are not too bad.

SNC essentially argues the latter, pointing to the relationship between gilt yields and the market's p/e ratio. High p/e ratios, it believes, are appropriate when yields on the alternative investment of gilts are low. On the SNC composite value indicator, which includes things like the gilt/equity yield ratio, UK shares are not over-priced.

The Wall Street worry is perhaps more serious. There is little doubt that US share prices are in heady territory. Professional US investment banks are still quite positive, but then their job is selling securities. Those sage observers of US financial trends, the Bank Credit Analyst editors in Montreal, are talking of a US share mania. They point out that the US bull market is already two-and-a-half years old and labouring in spite of record mutual fund inflows, themselves a bear signal. BCA's own buy/sell indicator has been saying 'sell' for several months, and while it has often been rather early in calling turns, it has been a good long-term guide going back to 1919.

Of course, a sharp fall in Wall Street need not particularly damage the UK, for by US standards UK shares are cheap. But it would stretch belief to suggest that there would not be some damage here were US shares to be downgraded. My own instinct is that UK markets do not yet feel sufficiently euphoric to be in serious risk of a crash, but if there is a burst of enthusiasm through the summer and autumn they could become vulnerable.

Of the Continental recession there is little new to be said, except that virtually every day brings further evidence that the downswing has a long way yet to run. From the UK point of view, the negative aspect is that nearly 60 per cent of our exports go there; the positive aspect is that more than 40 per cent do not. Exports to the rest of the world are running sharply up.

Finally, the danger of rising inflation and hence rising interest rates here in the UK: one effect of the increasing evidence of recovery is that the mood of the market has shifted from expecting further cuts in interest rates to assuming that there will be no early rise. While inflation remains muted, that looks a safe enough assumption, and there really can be no early danger of a rise in inflation. Indeed, it is quite encouraging in a way that so many commentators in the City are discussing the dangers of just such a rise: this is just the sort of vigilant climate the Bank of England needs to encourage if it is to be able to lean hard against inflationary pressures.

The conclusion should perhaps be that the market's present caution is itself quite a healthy sign. Share prices are already discounting quite a bit of the profit recovery that will be achieved: they are saying that things are fine for now, but beware of hiccups in the months ahead. If equities were really roaring away, that would give some very negative signals about the durability of the recovery. So the caution is itself a signal not to sell.