Market rally under threat now easy gains have been won

The City's "CNN traders" have preferred to focus on military gains in Iraq rather than the latest faltering economic data

Stock markets are prone to self-fulfilling prophesies, and one of the most recent has been that a sell off in the run-up to war would be followed by a rally as the war progresses. So it has proved. After another 121-point gain by the FTSE 100 yesterday, as coalition forces increased their presence in Baghdad, the UK market is now up 20 per cent since its low on 12 March, in the dying days of United Nations diplomacy.

At the peak of yesterday's surge, when the FTSE 100 was up 4 per cent and above its level at the start of the year, there was evidence that a number of the trading desks of the big investment banks were taking out bets the market would fall back.

For the past four weeks, the size and direction of the moves by US and UK markets has seemed proportionate to the perceived progress of the war against Saddam Hussein, complete with a wobble after the first week of the conflict. But many strategists and fund managers are predicting that the focus may soon switch from the battlefield back to the global economy – and that could bring the rally to a halt.

Khuram Chaudhry, a European strategist at Merrill Lynch, is unwilling to call the top just yet, but has words of caution.

"Many people have become 'CNN traders', watching what has been happening in Iraq and trading on sentiment rather than fundamentals.

"That can keep going until Easter, particularly now there is momentum behind it. But when the market refocuses on the fundamentals it will see that, if anything, these have deteriorated."

The point about upward momentum is important. While stock markets headed relentlessly down, a little bit of outperformance or underperformance, wasn't going to trouble fund managers as much as the prospect of missing out on a rally as dramatic as the one over the past four weeks. The psychological need to climb aboard has meant the stock market has gone like a train since 12 March. It has also forced the unwinding of big short positions, which a number of big hedge funds took out in January.

The numeric triggers for the rebound included the fall below 800 points by the S&P 500 index in the United States – the level from which it has already recovered twice, last July and October – and the closure of the "reverse yield gap", which pushed the dividend yield from shares above the return on gilts for the first time since the Fifties. These numbers are long gone now the equity market is up a fifth in value.

Other numbers might figure larger in the investment community's thoughts now. For instance, if you tot up the earnings forecasts for all the shares in the UK market, you would expect 11 per cent growth this year. Economists are forecasting earnings growth of something more like 5 per cent and GDP growth is likely to be revised down to 2 to 2.5 per cent or even 1.5 to 2 per cent by the Chancellor this week. There may still be lots of disappointment looming. Abroad, the disjoint between hopes and reality may be even larger, since the consensus of forecasts for US companies suggests 18 per cent earnings growth and European companies are forecast to grow earnings by 20 per cent.

"What we need to move the market on from here are some upward revisions to earnings estimates," says Darren Winder, strategist at UBS Warburg, "but it is not clear whether that can happen. UK consumer spending slowed in the first quarter, and with tax increases taking effect and house prices coming off, it is likely to slow further over the spring and into summer. That might feed through later in the year into pressure on earnings that may force a rethink."

More immediately, the US jobless figures and the first-quarter reporting season on Wall Street might prove to be enough excuse to take the shine off the recent rally.

The temptation to bank recent profits is clearly growing. As our table shows, investors who were able to snap up Granada shares on 12 March were sitting on a 48 per cent profit last night. Other shares in the media sector, which is always among the most volatile of the stock market sectors, have also had very strong runs. Among the best performing stocks have been life insurers and fund managers – whose fortunes are clearly geared to the performance of the markets and whose shares have been trashed in the bear market.

There have also been strong gains for the banks, with Barclays, Lloyds TSB, HBOS and Royal Bank of Scotland all up by more than a fifth. This sector was fingered by many as under-valued after the falls of early March, with many pointing to chunky dividend yields as evidence.

Chris Tracey, an investment strategist at JP Morgan Fleming Asset Management, has highlighted the importance of dividends in his latest strategy note for clients. In fact, he goes as far as recommending investors assemble a portfolio of shares yielding more than Government bonds. He said: "Through the worst excesses of the bull market, people completely ignored dividend yield as a criteria for judging companies. But it is a real measure of how well a company is doing, and it worked over the longer-term. It is real cash, so it can't be fiddled."

Many now expect dividends to make up more than half the average annual return from equities. After the late Nineties' assumption that shares will return upwards of 12 per cent a year, the consensus view is now for 6 or 7 per cent. If a fund manager – expected to make that more pedestrian sort of return – can pick up a share with a yield of more than 4 per cent, most of his work has already been done. This is actually pretty normal on a long historical view: dividends accounted for about two-thirds of annualised returns from equities over the 20th century.

The reception Mr Tracey's strategy document received from clients last week is instructive. He suggested that long-term investors should move into the equity markets after sharp falls, not relief rallies such as the current surge, but this suggestion was met coolly. He characterises this as the reverse of the situation at the top of the bull market, when investors knew valuations were ludicrous but were too scared to sell.

The focus on dividends, though, was warmly greeted, but not everyone agrees this will be unequivocally to the long-term good. Mr Chaudhry at Merrill Lynch identifies it as a drag on economic growth and it could contribute to a weakening in just the economic indicators the market is starting to worry about.

He said: "The labour market shows US unemployment is drifting upwards, and that is because investors are rewarding companies that are cutting costs and paying dividends rather than putting money into investment and capital expenditure."