Money: If lower volatility is the new norm it is possible to envisage the `golden age' staying a while

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The Independent Online
Instead of debating the issue, let's start, for a change, with the assumption that the world's equity markets are very highly valued by historical standards. What follows from this conclusion? One plausible explanation, as I mentioned last week, is that there has been a profound and secular change in the way that shares are now valued.

The world-wide fall in inflation, and the consequent reduction in inflation and interest rate expectations, is the obvious why such a change may have occurred. But is it a plausible explanation? And if not, what other factors could be at work.?

These questions were addressed this week by the economist Bill Martin and his colleagues at UBS, the big Swiss-owned stockbroking firm. Their conclusion is that the change in inflation alone does not provide an adequate explanation of the stock market's recent climb into stratospheric territory.

Their view is that what has happened is mainly the result of two factors: a reduction in the volatility of economic growth and interest rates all round the world; and the decoupling of the American, European and Japanese business cycles for the first time in many years.

Both combine to reduce the traditional uncertainty, or risk, associated with equity investment. They find, from looking at the recent economic data, that much of the re-rating of shares that has taken place can be attributed to the unprecedented stability of changes in the rate of economic growth in the current decade. As Sherlock Holmes might have remarked, the remarkable feature about the 1990s in economic terms, has been the absence of any cyclical shocks.

The US economy for example has continued to grow at a steady lick with none of the periodic setbacks that one would have expected and the UK's experience has not been much different. Since 1992, at least, the rate of economic growth in this country has been remarkably consistent. Interest rates have also been more predictable, and less volatile, than they were. This has had a steady and benign effect on the price of shares. Dividend yields in the US and UK markets, though not in Japan, have fallen consistently since around 1990, reflecting the growing consensus among investors, in the words of UBS, that the business cycle has "been tamed".

This seems to me a useful insight into what has been happening to share prices. There can be no doubt that the unusual stability of the economic climate has contributed to the remarkable rise in asset values that we have seen recently in financial markets. Investors dislike uncertainty more than anything. In theory, if they can be persuaded that the cyclical ups and downs of the past have been moderated or even eliminated, it is entirely logical for them to pay a higher price for assets, company shares, whose value today ultimately derives from their ability to generate profit and cash flow in the future. The more certain these future cash flows are, the more valuable the shares will become.

But is this the only explanation of what has happened in stock markets to send them soaring to record levels? UBS is honest enough to say it thinks not.

It estimates the lower volatility of returns explains only a portion of the recent remarkable re-rating of shares. So the UBS is reduced to looking for a simpler explanation for this phenomenon. Its suggestion is that the other big factor in the re-rating of shares has been unprecedented decoupling of the American economy from its counterparts overseas.

Whereas before, the three big regional economies regions, the US, Europe and Japan, have tended to move in a broadly similar direction, that trend has been broken in the 1990s. As my chart suggests, experience since 1991 has been much more unco-ordinated. Partly this seems to be the result of differing policy preoccupations, but partly also of some exceptional events - German reunification, Japan's dose of debt deflation - which have thrown the traditional relationships off course. For investors, critically, what it has meant is that the world economy, taken as a whole, has behaved in a less cyclical way than before.

What matters to investors now is whether this happy, benign state of affairs can persist for much longer. If economic conditions are to become more volatile again in future, then we should expect to see some adverse future impact on share price valuations.

If however, there has been a genuine and profound change in the way that the markets operate, with lower volatility a new norm, then it is possible to envisage the current "golden age" for equities persisting for some while yet.

Which will it be? UBS is in the more cautious camp. Mr Martin makes the point that one-off events, by definition, tend not to recur. The recent "decoupling" is largely "a fluke", he says, which is likely to lose its force in the next few years: if history is any guide, volatility will return in due course.

The historical parallels are not entirely encouraging. Previous occasions when economic conditions have been free from violent swings in output and interest rates - such as the 1920s and the late 1960s - have tended to be followed by rather violent setbacks in the value of shares.

The last time that people started talking about the "business cycle" having been "tamed" was, as UBS reminds us, in the bull market of the late 1960s, when blue chip companies on Wall Street were selling on ridiculous multiples - 40 or even 50 times earnings.

Things are not quite so extravagant this time round, but recognising that the current investment climate is benign is a useful cautionary reminder against entertaining too extravagant expectations for the future.

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