What the markets will do in 1999

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The Independent Online
THE MOST surprising thing about stock markets last year was their resilience. Taking as a benchmark the performance of Wall Street, which was mirrored in subdued form by London, equities defied the bearish predictions that littered the pages of the financial press at the turn of the year, or at least, many of the market leaders did.

Personally, I advised readers to be wary of Wall Street and not to expect miracles from London. I cannot claim this was entirely sound advice, though my judgement on Japan - avoid like the plague - proved as percipient as ever. Despite the warnings of economic slowdown from the Far East, the Dow Jones Industrial Average raced away, hitting an all-time peak on 17 July of 9380.2, up a staggering 18 per cent on its level at the start of the year.

Nor did this turn out to be the last desperate gasp of the bull market. There was a crash, sure enough, but it bottomed out at a higher level, and much sooner, than most of us would have predicted. The Dow is now back at close to its peak. If this recovery is sustained - and that's still a big "if" - then what happened in the late summer/early autumn will go down in history as the shortest bear market ever.

We are becoming, I guess, quite used to this phenomenon. The market crashed, then promptly uncrashed, at about the same time in 1997 too. On both occasions what rescued markets in the US was the extraordinary optimism and nerve of small private investors. Over the years, they have learned that it pays to buy on the dips. The contrary strategy, which is played out in a sustained bear market, of selling into the rallies, just failed to materialise.

Even so, with valuations at their present heady levels, the dangers of the buy-on-the-dips approach are increasingly apparent. The picture is very mixed, of course, with the apparently insane valuations put on Internet and hi-tech stocks quite out of kilter with the more reasonable ratings afforded to companies in traditional industries.

But the overall impression is still a very challenging one. Wall Street has staged its recovery despite growing signs not only of a slowing economy but, perhaps more importantly, of much more pedestrian corporate earnings growth.

These valuations may have looked reasonable while analysts were continuing to predict double-digit earnings growth into the medium-term future, but hardly anyone is doing that any longer. Here in Britain, corporate earnings are unlikely to rise at all this year - they may even fall.

Perhaps as worrying for US valuations, the savings ratio - that is the amount people save out of income - has fallen close to zero. There is growing evidence that the wealth effect of the bull market has helped sustain the US's consumer and economic boom. Since people expect their savings to grow with the stock market, they have begun to believe they can spend more and save less as well. Obviously, this cannot go on for ever.

In the end, however, shares, like all assets, are worth what people are prepared to pay for them. If investors will happily fork out much higher prices than they used to, so be it. Any setback in prices is regarded as a buying opportunity. The sixty four thousand dollar question is for how much longer this can continue.

My own guess is that it will be for a little bit longer yet. If stock markets can survive what was thrown at them last year without plunging into the abyss, then they certainly ought to be able to weather whatever shocks the world economy has in store for them this time round too. Of these, the most immediate threat comes from Brazil and the rest of Latin America. A meltdown there might have a far more damaging direct effect on the US economy than the Far East, since the region is also a more important trading partner.

However, I suspect that the psychological impact on markets - the contagion effect - will be less severe, if only because markets are now used to these shocks and have to some extent already discounted them. They have also become accustomed to the idea that if things get really rocky, central bankers will ride to the rescue.

Interest rates have been cut sharply across the Western world since the autumn financial crisis hit. And when the excesses of Long-Term Capital Management threatened general systemic damage, the US Federal Reserve organised a rescue. Investors can hardly be blamed for thinking that there is an effective safety net, however much central bankers protest that this is not the intention.

There are plenty of other reasons for thinking we are not yet in a sustained bear phase. The amount of merger activity remains high, both in the US and Europe, and share buybacks show no sign of a let-up, further swelling the pool of cash looking for a good investment home. With emerging markets and Japan now no-go areas for Western investors, where else but their own stock markets can they look?

All these factors are underpinned by the continued strength of Western bond markets. Falling inflation, shading into price deflation, means that the immediate outlook is for ever-cheaper money. This in turn makes equities look cheap in relative terms, always assuming, of course, that the traditional relationship between bond and equity yields is broadly maintained.

Furthermore, it is a mistake to judge equities as a whole by what is going on among the market leaders. The FTSE 100 index finished the year up nearly 15 per cent, but the next largest 250 companies, as represented by the FTSE mid cap index, on average barely rose at all. As for the small cap and fledgling indices, they closed a fair bit lower. And even within the FTSE 100, the picture was very mixed.

In short, the makings of the sort of radical shift in investor psychology that might cause western equity markets to go into sharp decline just don't seem to be there right now. That's not to say I think Wall Street and London rip-roaring buys. I'd be amazed if these markets record double digit growth this year. With the euro launch providing a following wind, I suspect the best value will be had on the Continent, and particularly from Frankfurt and Paris.

My advice on Japan is the same as it has been for some years now. Don't be beguiled by those who insist that after a 10-year bear market, Tokyo is on the verge of revival. Valuations in Japan are still far higher than the US and Europe, while economically, the country is in much worse shape. Need I say more?