Investments

What is the outlook for the world stock markets now that both Wall Street and the London market have passed their latest numerical hurdles - 6000 on the Dow Jones and 4000 on the Footsie index? The numbers, though nice round figures, have no significance in economic terms. But they do provide a good moment to stop and take stock of where the balance of argument between bulls and bears now lies.

As it happens, the direction of the markets was the subject of a whole day conference last week by the strategists at James Capel, one of the City's best surviving research-led broking houses. Even allowing for the fact that brokers are paid to be optimistic, they put forward a lot of good arguments to justify why they remain fundamentally optimistic about the current level of the markets.

Capels have said all along this year that they expect the main stock markets to keep powering ahead and events so far have more than borne them out, despite much scepticism from their rivals along the way. Their forecast is for the London market to rise a further 10 per cent over the next year, despite the inevitable imminence of political worries ahead of the next election. This is how they make their case.

Wall Street may be overvalued if you look only in absolute terms at the main valuation measures such as dividend yield and price-earnings ratio. But once you adjust for the secular decline in long-term interest rates, and for the impact of the business cycle, it becomes much easier to explain. Put another way, American companies have for most of the last 15 years consistently been earning returns on their investment which are comfortably ahead of their cost of capital.

This was not the case for almost the entire period between 1972 and 1982, and again, more briefly, in the 1990-92 recession. The implication is that the dream ticket combination of rising earnings and falling interest rates may still have some way to run, though even Capels concede that we must now be approaching the end of the current bull phase of the stock market cycle.

The picture in the UK is, if anything, more positive, according to Capels. It is not just that the UK stock market tends to lag Wall Street, though it has fallen much further behind the American market in relative terms than the historical averages suggest. More important is that British industry too has been undergoing a positive renaissance. Unlike previous recoveries, when most of the profit gains have been driven by higher prices rather than by efficiency gains, this time both profit margins and return on capital have benefited from direct management action. In a low inflation environment, managers have taken full advantage of their new freedom to manage.

As a result, profits have been rising almost twice as fast as the economy as a whole - 12 per cent against 6 per cent in nominal terms last year, and a probable 16 per cent against 5 per cent this year. According to Robert Buckland, the UK strategist at Capels, investors who look solely at overall market valuation measures and macro-economic figures are in danger of missing out on what is taking place inside the boardrooms of UK plc. While the overall rate of earnings growth at UK quoted companies may now be slowing down, the gains in real and relative terms continue to be impressive.

Comparing the return on shares with that on gilts and cash, there is no evidence that the market is anything like as overvalued as it was before the 1987 crash. The reason is that the quality of company earnings is higher while the interest rate outlook remains much more benign (though pressure on service sector inflation could push interest rates up next year).

Most surprising of all, perhaps, the Capels team is still refusing to write off the Tories' chances at the next election. They base this view partly on the fact that the feelgood factor is now starting to return with a vengeance. Consumer spending and the housing market are both reviving, as the Chancellor clearly intends, and consumer confidence, as measured by the polls, is actually above its long-run trend. The Government's problem is that it is not getting the political credit for the economic revival which it would have done if the traditional relationship between economic well-being and the polls had not broken down so drastically in the last four years.

The ERM crisis and the Blair phenomenon are the two most important ingredients in this reversal of fortune. But even here not all is lost. The most recent polls show a sudden narrowing of the Labour party's lead over the Government on two key measures: which party is credited with the greater ability to manage the economy, and which is considered likely to take the most favourable line on tax. The polling gap, conclude Capels, is certain to narrow over the next few months. Their view is that the next election is far from being lost. If so, that prospect will help the market to overcome its traditional pre-polling jitters.