You know you’re in a bull market when bad news is simply shrugged aside and even the most indifferent events are greeted exuberantly. The result of February’s Italian general election, which drags the future of the eurozone back into question, would have induced market panic had it come nine months ago. But the world’s equity markets barely blinked before resuming an attempt to breach all-time peaks.
Something similar happened last week when the US Congress failed to agree how to avoid the package of mandatory spending cuts known as ‘the sequester’. When Republicans and Democrats came up with these cuts in 2011, they were so potentially damaging it was unthinkable that any party could actually contemplate allowing them to come into force. Or so they thought. When the deadline for avoiding the sequester passed without resolution, Wall Street barely twitched.
Wall Street — like most of the world’s stock markets, which tend to follow its lead — has been on a tear ever since it learnt to stop worrying about tiresome European news and started focusing instead on tangible signs of recovery at home. Since last July, when the European Central Bank president Mario Draghi vowed to do ‘whatever it takes’ to save the euro, the US stock market has moved in one direction only, buoyed by confirmation that its previously free-falling housing market, a key economic driver, has finally taken a decisive turn for the better.
US indices have risen more than 15 per cent and the rally could go on. Market strategists at the big investment banks have been strenuously pushing the case for shares since the new year. Some even make the case for a ‘market melt-up’, meaning a market in which prices start to run away under nothing more than their own momentum — because big investment institutions can’t afford to be left behind in a rising market. The longer it goes on, the greater the pressure to join in, whether they buy the argument or not.
A market melt-up cannot be ruled out, but is not the most likely outcome. The longer shares press on without a significant setback, the sharper and more likely the next correction becomes. Company earnings, on which share prices ultimately depend, are forecast to grow by around 7 per cent this year — hardly spectacular, even if you believe the figures. Which you shouldn’t: for each of the past four years, analysts’ consensus start-of-year earnings estimates have been reduced as the year progressed, leading to mid-year market declines.
On most traditional measures, shares as a class do not look overly attractive. In their definitive analysis of global investment returns since 1900, the London Business School professors Dimson, Marsh and Staunton conclude that current valuations point to an annualised future rate of return of 3 to 3.5 per cent a year after inflation. That’s positive but still some way below the long-term average. Neither dividend yields nor price-earnings ratios suggest a market that is obviously cheap. (Europe, because of its obvious political risks, and Japan, which is finally setting a course to fight its way out of deflation, look better bargains if valuation rather than risk is the primary criterion.)
The two most important things that shares have going for them are that they offer a measure of protection against future inflation, which is almost certainly on its way — and that they are not government bonds, whose yields have been deliberately driven down to ultra-low levels by the easy-money policies of western central banks. The long-term argument for overweighting equities against government bonds in these conditions is irrefutable.
However — as Tim Price argued here recently — as long as central banks continue to use the printing presses in an effort to kick the economy into action, the scope for the price of government bonds to continue defying traditional investment logic remains. It could take several years for government bonds to revert to more appropriate levels. Too many investment institutions have reasons, or excuses, to go on owning them.
And despite the relative attractions of shares as a class, stock markets face an important technical hurdle. Having more than doubled since their low point in 2009, the main US indices are now within touching distance of their 2007 all-time highs (1,565 for the S&P500, 14,164 for the Dow Jones Industrial Average). If they pass these levels and stay there for more than a few days, it will be a powerful signal that investors are prepared to put historic concerns aside and take the market higher still. The FTSE 100 index is also closing in on its all-time high of 6,950, reached way back in December 1999.
So although equities remain the best of an indifferent set of choices for longer-term wealth preservation, I would venture that the smart money is still against the stock market breaking decisively out of the broad trading range it has been in since 1998. Many old City hands nurture the suspicion that we may need one more nasty bear market before we can finally declare victory over the financial crisis. The Great Winfield, a fictional character in The Money Game — a classic account of the 1960s bull market by ‘Adam Smith’, pseudonym of New York writer George Goodman — made a point of only employing young men to run his funds.
He rationalised it this way: ‘The strength of my kids is that they are too young to remember anything bad, and they are making so much money that they feel invincible.’ While the economic backdrop is very different today, the majority of market participants have never lived in a world in which bond yields go up, rather than relentlessly down. Nor have these youngsters known the miseries of stagflation, let alone a full-blown sterling crisis, which is an ominous spectre hovering over the future of the UK -economy.
All these risks remain. In the long run the stock market reflects the way the economy and company profits go, but for long periods it can blithely follow the path of its own self-fulfilling perceptions. This spring, brokers are whistling their way to work. That’s encouraging, but don’t be lulled into thinking that there won’t be further turbulence ahead. As bull markets go, this one has still to prove itself the real, enduring deal.
Jonathan Davis is the author of Money Makers: Stock Market Secrets of Britain’s Top Professional Investment Managers.