US spring fever sends a positive message
Tuesday 28 March 1995
So much vastly expensive time is put into justifying any market movement that anyone seeking to make sense of it all tends to find the signals drowned out by the background noise. One example of this over-supply of information is the variety of "valuation indicators", indicators that purport to show whether shares, in historical terms, are expensive or cheap.
Thus Goldman Sachs lists five valuation indicators for UK shares, while Socit Gnrale Strauss Turnbull shows eight. It is all quite interesting if you like that kind of thing, but also liable to confuse.
So let's start with the most basic indicator of all: the level of share prices in real terms - what would have happened to share prices had there been no inflation? The results for both the US and the UK markets are shown in the graph. The run goes back nearly 25 years, so it should be long enough to have some meaning. What messages might one draw? The most obvious is that share prices in the UK are now only about 10 per cent higher than they were at the beginning of 1972; US share prices are up some 20 per cent. On that basis, the reaction of most people would be to say that, though share prices might be fully valued now, they are not vastly overvalued.
But now look at three slightly less obvious messages. Put your hand over the left hand side of the graph and look at the solid line showing British share prices. You see the sort of performance that investment companies use in their advertisements: several hiccups, but generally a solid upward movement.
Now put your hand over the right-hand two-thirds and you see the reverse: the nightmare of plunging values, taking UK markets down to some 40 per cent of the early 1972 levels throughout the whole of the second half of the 1970s (and briefly down to 20 per cent at the beginning of 1975).
Finally, put your hand over the left-hand two-thirds and you get a picture that is basically flat: between spring 1987 and the present there has been no strong overall trend.
For the US there is a slight shading of difference. The US market has in general been less volatile than ours. The two move together to quite a remarkable extent, but our early 1970s plunge was steeper than theirs and their market has been generally stronger over the last five years than ours. However, the similarity is surely more interesting than the differences. Get the timing right in one market and you would make money in the other.
That gives an answer to the second question posed at the beginning of this commentary: if the American investors are right and the new levels for share prices are sustained, then it is highly likely that prices in the UK will catch up. Indeed there is already some leeway.
If one does take that view, there are plenty of ways of justifying it. Goldman's analysis suggests that UK shares are 15.5 per cent undervalued, which by co-incidence would bring them up in real terms to something close to the US levels shown on that graph. Socit Gnrale's analysis leads it to predict an FT-SE 100 at 3,500 to 3,750 by the end of this year, a slightly more bullish outlook. So the notion that we ought to catch up with America can be justified by the professionals over here.
But what about the initial question on the US spring fever: what can one sensibly say to that? Go back to the graph and consider this proposition: if one looks at all the changes that have taken place in the US corporate sector over the two decades, surely all those companies ought to be worth 20 per cent more in real terms than they used to be then.
That must be right. The corporate sector is larger; the companies within it are very much more efficient; the market they supply is larger. The valuation may be rather too high, but it is not absurdly high. But then one might ask: what about the experience of the 1970s? I think that we have to accept that the very rapid inflation of the 1970s seriously damaged both the company sector and the whole investment climate.
Another explosion of inflation is most unlikely, thanks to the power of the bond markets: if inflation were to rise sharply they would push up long-term interest rates and choke it off. Some of us expected the crash of bond prices last year to lead to a parallel weakness in equities; in fact their action may have prevented such a crash by averting the possibility of runaway inflation.
Of course there could be a sharp correction in US prices. More likely they are on a plateau. Either way, the implications for the UK are rather positive. In investment, we are copycats.
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